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Guaranteed Hedge & Absolute Return Funds Uncovered

The way I have found it easiest to understand these complicated products is to stand back and ask how the fund can produce a return in the first place as well as provide a guarantee. Of course, it can't most of the time and here are possible reasons why!

Equity markets in the developed world have delivered a 9-10% per annum return (before costs) on average since 1900. That level of return was 5-6% over inflation and 3-4% over the risk-free alternative (long-dated government bonds). This extra 3-4% over long-dated government bonds is the premium return one obtained for taking the risk.

Hedge and absolute return funds follow a variety of strategies to extract the risk premium available from equities as well as from other financial instruments and currencies. One such strategy might be to buy a high yielding currency and sell a lower yielding currency in an attempt to extract the differential. Another might be to buy equities, financial instruments or currencies that are trending upwards and sell those that are trending downwards - also referred to as trend or momentum investing. Still another strategy might be to buy high yielding non-investment grade corporate debt and finance it with cheap short-term debt. But in my travels, I have not come across any strategy where the risk premium available is better than simple equities. And this makes sense to me as businesses actually produce goods and services to sell, and they make profits as a result. The returns to business on the capital invested, in aggregate, will generally be higher than bank deposits. If this was not the case, why would the businessman bother?

Hence, hedge and absolute return strategies can generally only outpace equity-like returns by using leverage (debt), and that entails higher risk.

I think we can conclude, therefore, that, without leverage, hedge and absolute return funds cannot, in aggregate, generate returns higher than equities. Indeed, as the costs in hedge and absolute return funds are much higher than standard equity funds, we can reasonably conclude that achievable returns from the hedge fund industry might be in the order of 6-7% per annum and below the 9-10% achieved by equities this past century.

The ability of hedge funds to go short (sell what they don't own) as well as long in pursuit of the risk premium provides returns that are less volatile, and this can add balance to an investment portfolio. However, my own studies show that the global hedge fund industry has delivered miniscule returns since 2002, and negative returns after inflation. In addition, the industry acted in a highly correlated fashion to equities in both of the down years of 2008 and 2011.

What I mean by this is that hedge funds, in aggregate, lost money alongside equities in both 2008 and 2011. In effect, they did not provide offsetting returns, which is supposed to be their main attraction. Is it possible that the industry is now much more correlated to standard equities just as Ireland is embracing the product - or should I say just as the IFAs, banks and stockbroking community are in desperate need to sell something other than a standard equity or property product? But let's put aside these additional reservations and assume a 6-7% annual return from the hedge fund industry!

This 6-7% still does not leave much room for the costs of providing the guarantee or the considerable (and often poorly outlined) costs of manufacturing and distribution of these structured products to the consumer.

Hedge and absolute return funds are a valid asset class but their returns will be below equities, and probably considerably below, in the medium to long-term. As we have been in an equity bear market for the past 13 years, this fact is easily forgotten.

In addition, if hedge funds are supposed to deliver positive returns with lower volatility than equities, then why does one need a guarantee? You can reduce, if not eliminate, the risk of any particular hedge or absolute return fund letting you down by buying a range of them.

I think most people reading this will rightly conclude that a guaranteed hedge fund product exists solely to reward the sellers. In Ireland, at present, the offer of capital protection alongside equity-like returns is being advertised. However, these claims surely depend on the high deposit interest rates still being offered by the Irish banks. In other words, these high return claims are possible only because the banks, which remain credit risks, are providing high interest rates at a time when the ECB overnight rate is 0.75%. This allows the manufacturer of a guaranteed structured product to place less of the monies raised on deposit with the bank as, at the higher rates of interest, this lesser amount will roll up to provide the 100% capital guarantee. In turn, this frees up a greater proportion of the monies for investment into the hedge fund tracker instrument.

So long as the customer fully understands this underlying credit risk, then I see no issue. But then surely in this instance the customer might be as well off simply placing his money in a medium-term deposit account with that same bank. At least he gets the higher than normal bank interest return and can understand the risk (the bank). But, of course, there is no room in this logic for investment intermediaries other than those who charge a fee.

However, in normal market conditions (which most of us can't remember), if it is a high return, no risk investment you want, it does not exist.

It is my view that this industry we have works against the customer, and for as long as IFAs, stockbrokers and banks are allowed to earn commission from product sales, it will remain this way. One cannot expect the customer to understand these issues. Is that not why an IFA exists - to provide impartial financial and investment advice to his client? Indeed, I have come around to the view that banks should be banned from selling investment products of any nature to customers...they are wholly conflicted.

Many IFAs reading this may conclude that I am overly negative on the industry. But my thinking also leads to me to conclude that if the Regulator would ban banks and stockbrokers from selling investment products for commissions then the opportunity exists to have a professional IFA network in Ireland perhaps a multiple of its current size, manned by properly trained IFAs earnings a fee like any other profession, and in a better position to serve the consumer in an impartial way, as do accountants, solicitors, doctors and tax advisors (largely).

That guaranteed hedge & absolute return funds are selling in huge quantities in Ireland at present - as technology funds were in the late 1990s and as geared property funds were in the 2005-07 period - is surely a symptom of a dysfunctional market where the customer's returns are silently transferred to the seller. Only the Regulator can change this, in my view!

Rory Gillen
11th September 2012