You're travelling through another dimension; a dimension not only of sight and sound but of mind. A journey into a wondrous land whose only boundaries are that of your imagination, where alpha roams free and high correlations are rare. That's the signpost up ahead - your next stop: the world of absolute return funds or hedge funds, as they are more commonly known.
Why the twilight zone? Because absolute return investing is such a hard term to define, throwing up so many variant possibilities.
Hedge funds are in a different world.
Hedge funds are a strategy rather than an asset class. There is more than $1.225 trillion invested in hedge funds globally with more than 9000 hedge funds on offer, according to Chicago-based Hedged Fund Research Inc.
Hedge funds are not subject to the same constraints as more traditional long-only investing. They offer investors the ability to capture additional sources of return. Research from AllianceBernstein suggests hedge funds have generated after-fee returns on par with equity market returns but with less than half the volatility.
The challenge in traditional portfolio construction has been that the majority of the portfolio risk is attributable to equities. In a typical balance fund portfolio (70:30), in excess of 85 per cent of the portfolio risk will be attributable to equities. This risk is hard to completely, or even partially, offset.
The low correlation of hedge funds with equities and higher return potential than fixed interest, which were traditionally used to offset equities, makes them an appealing strategy for any portfolio manager or adviser.
Looks can be deceiving
While there are good reasons to incorporate hedge funds into portfolios, there is often more to them than meets the eye.
Low transparency in some hedge funds can mean it is difficult to tell how much exposure there may be to market risk. The diversification potential of hedge funds is reduced with funds that have a material exposure to beta (market risk).
A recent study by JP Morgan examined the return from hedge funds from 1994 to 2006. The research found that while the excess return remained high throughout the period (+7.2 per cent) an increasing part of this return in the period 2002-06 was the market return. The return attributable to manager skill (alpha) fell from 47 per cent of the return (1994-2000) to 36 per cent (2002-06). Part of this decline in alpha was due to the increasing flows of capital, arbitraging inefficiencies away.
Not only do portfolio managers and advisers need to understand, and be wary of, the re-badging of beta under the term 'absolute returns', but also the contribution from hedge fund managers' style in its interaction with the market. For example, a market-neutral manager matches their long exposure (buys) against their shorts (sells). Performance depends on whether the longs outperformed the shorts. It is difficult for the manager to eliminate all remnants of market bias, such as capitalisation and style biases. It is hard to uncouple the horse completely from the cart.
The risk of getting it wrong is high
There is a wide dispersion of manager returns, with the difference between top and bottom quartile hedge fund managers six times greater than it is for traditional share managers. Hedge funds may underperform when markets run exceptionally hard (as has been the case recently). Superior performance has also been difficult to sustain, making ongoing research just as important as initial selection.
The level of risk taken in more recent years by low volatility fund of hedge funds has reduced greatly due to the lower volatility across markets and also a greater focus on risk management. The result has been lower absolute returns for these types of hedge funds.
There is growing concern about the impact of funds under management growth on returns for hedge funds. Lower returns from some hedge fund strategies will put pressure on fees, which are high compared to long-only funds.
While the supply of new funds will keep up with growing demand, this may be at the expense of quality. Failure rates are high by comparison with long-only managers.
The most important factor to succeed with hedge funds is selecting a manager with proven skill. This is no easy task as many of the funds are complex and in some cases there is a lack of transparency, although it has improved.
Much of the risk in hedge funds is not conventional. Advisers should look beyond ratings that are biased towards returns only and instead focus on more qualitative ratings that take into account operational risk, quality of the business and the depth of the team.
Congestion in the more traditional markets, combined with low market volatility, has led to the reduction in alpha from traditional fund manager approaches. In this environment, the twilight zone of hedge funds looks tempting, particularly as there is considerable potential benefit in including these strategies in portfolios to increase diversification and to offer another source of return. However, it is a journey that must be taken with great caution.
