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Investing in Hedge Funds: Should You & How To?

Summary
This article aims to address three issues for investors:

  1. Why one might consider investing hedge/absolute return funds?
  2. Whether the industry or asset class has delivered worthwhile returns to investors over the long-term?
  3. How an investor can source hedge/absolute return funds already trading on stock markets, and how the funds that GillenMarkets have covered (and recommended) fared over the medium-term?

Hedge funds gained popularity as an asset class in the early to mid 1990s, as a way for investors to generate returns above inflation and bank deposits without exposing an investor to the risks associated with general equities, which are directly affected by the performance of underlying economies. Equities may have delivered the best returns historically, but an investor takes on the associated economic risks.

In contrast, hedge/absolute return strategies aim to deliver returns above inflation, but without the same dependence on the economy. If they achieve that aim, then hedge/absolute strategies (and funds that follow them) are an alternative asset class that could provide essential diversification benefits for an investor's portfolio. This article aims to uncover whether the hedge/absolute funds industry is living up to its aims (claims) and how the hedge/absolute return funds that we provide coverage of for members of our website have performed in the past.

As is often the case with theories, the actual ability to deliver inflation-beating returns, uncorrelated with general equities, has proved more difficult than the hedge fund industry admits. Over the 12-year period from 2004, the HFRX Global Hedge Fund Index has generated paltry returns of only 1.1% compound per annum, failing to beat inflation and actually declining along with global equities in the credit crisis of 2007/8.

But, the idea that the inclusion of hedge funds in a portfolio can be beneficial still holds true - if an investor can locate funds that are managed by teams with a good understanding of risk and a robust investment strategy. The seven hedge/absolute return funds that we cover on our website are all listed on the London Stock Exchange (LSE) and possess, we believe, these characteristics. These seven funds generated returns of 8.7% compound per annum since 2004, compared with returns of 8.0% from the FTSE World Equity Index. If an investor had allocated just 20% of his monies to these seven hedge funds (and 80% to equities), they would have reduced the volatility of their portfolio by 18% without sacrificing any return. For the investor with a low risk appetite or a short time horizon - e.g. with a near-term need for cash, or investors who depend on their portfolio for a living - hedge funds can provide important safeguards against the risks inherent in equity investing. 

The Five Main Asset Classes
Since the hedge & absolute return fund industry came into mainstream investing in the late 1990s, there are essentially five main asset classes for investors to consider:

  1. Equities (property being a sub-sector)
  2. Commodities & Precious Metals
  3. Long-dated government bonds
  4. Bank deposits/short-dated government bonds
  5. Hedge & Absolute Return Strategies

As bank deposits, short-dated bonds and long-dated bonds offer you a guarantee of your capital back, they are considered non-risk assets. As you get no such guarantee with equities, precious metals, commodities and hedge & absolute return funds, they are rightly described as risk assets.

The Investing Rationale for Owning Hedge/Absolute Return Funds
The general economy can be classified as being in one of four states at any point in time: prosperity, recession, inflation and deflation. While prosperity is generally good for equity and property prices, the other three economic conditions are negative for equity and property asset returns. Precious metals protect against inflation over the long-term, bank deposits generally provide reasonable returns even in a recessionary environment and long-dated bonds offer protection against deflation. Equally, hedge & absolute return strategies (and funds that follow these strategies) are not dependent on the state of the economy for their returns, and offer an additional asset class that can generate returns above inflation. That gives investors more choice and diversification opportunities when building an investment portfolio.

Equities and property have proven, over the long-term, that they offer the best returns so long as they are reasonably valued at the outset. But not all investors can wait for the long-term while others simply want lower (economic) risk in their investment portfolio.

In theory, hedge & absolute return funds should generate returns for investors that have little to no correlation to equities or the economic backdrop; that is to say, these funds should - whether markets and the economy have gone up, down or sideways - continue, over time, to eke out steady returns somewhere above bank deposits and inflation, but probably below the returns that have traditionally been available from equities.

Thus, the rationale behind an investment in hedge/absolute return funds has two facets:

  • Hedge/absolute return strategies (and funds that adopt such strategies) aim to generate returns from markets and financial instruments, but with no real dependence on the general economy. Hedge/absolute return funds attempt to generate returns above bank deposit rates and inflation, while limiting the dependence of those returns on the general economy. In this way, the returns this asset class can produce are uncorrelated to equities.
     
  • Where an investor feels that equity markets are overvalued or where an investor does not want to take on the risks associated with equities - which are dependent on a positive economic backdrop - an allocation of some monies to hedge/absolute return funds can be justified on the basis that diversification reduces the risk of significant losses in your portfolio.

Returns on Funds Covered at GillenMarkets
At GillenMarkets, we cover seven hedge/absolute return funds for our subscribers, each of which has, in our view, an excellent long-term track record. The table below highlights the growth in each of the funds' NAVs (with dividends added back), and compares them with the HFRX Global Hedge Fund Index, an index which measures the performance of the hedge fund universe and the FTSE World Total Return Index in dollar terms. The comparison is not entirely accurate as the various funds are denominated in a variety of currencies, but its close enough.

Table 1: Hedge Fund Returns
Year Fund #1 Fund #2 Fund #3 Fund #4 Fund #5 Fund #6 Fund #7 Average HFRX
Global
FTSE Wor-
ld TR ($)
2004 - - - - 7.0 - 0.0 3.5 2.7 16.1
2005 - - - - 16.1 - 7.5 11.8 2.7 11.7
2006 - 6.8 - - 0.2 - 9.1 5.4 9.3 22.2
2007 24.4 11.6 - - 5.2 13.3 8.8 12.7 4.2 12.7
2008 23.2 8.7 - -39.0 24.0 -5.9 2.3 2.2 -23.3 -41.8
2009 18.0 21.5 - 40.2 13.7 18.8 7.9 20.0 13.4 36.2
2010 1.0 8.0 - 36.0 15.1 9.6 7.3 12.8 5.2 13.2
2011 12.4 2.3 - 0.0 0.6 2.4 -5.7 2.0 -8.9 -7.3
2012 3.4 5.9 - 21.7 2.9 7.0 0.4 6.9 3.3 17.1
2013 3.9 2.1 -9.9 26.2 9.0 6.6 18.1 8.0 6.8 23.3
2014 0.6 7.1 14.5 9.8 2.0 4.8 -0.7 5.4 -0.4 4.8
2015 YTD 2.5 2.8 13.7 1.7 4.8 4.6 9.9 5.7 2.9 6.7
                     
Compound
p.a.
10.7 8.4 5.3 9.3 8.4 6.7 5.6 8.7 1.1 8.0
Discount -4.9 -5.0 -0.8 -2.3 -2.3 0 0 -3.1 - -


Since 2004, the HFRX Global Hedge Fund Index has grown by 1.1% compound per annum (failing to even beat inflation over that timeline) and the FTSE World Total Return Index has returned 8.0% c.p.a. over the same time period. In contrast to this, a £1,000 sum invested in each of the seven funds that we cover at the date of their inception would have returned 8.7% compound per annum, outperforming both global equities and the general hedge fund universe (although this doesn't account for currency issues, as both indexes are in dollars). In addition, the basket of funds never, collectively, had a down-year over the 10+ year period, despite significant down years for several of the funds, including Fund #4 (in 2008) and Fund #3 (in 2013) in both their first years' of existence.

Thus, a basket of the seven funds that we cover would have provided an investor with: (a) returns modestly above what has been delivered by global equities; and (b) returns that had low correlation with equity markets, providing essential diversification benefits for the investor.

The Benefits of Diversification: A Practical Example
Of course, it's all well and good to talk about the benefits of 'diversification', but what exactly does this mean for the average investor's portfolio?

Value of €10,000

We believe the following chart on the right does a good job of explaining why exactly hedge funds can be a useful addition to a portfolio. The chart shows the value of €10,000 invested, starting in 2004, in: (a) the FTSE World Total Return Index; and (b) a portfolio consisting of the seven hedge funds that we cover on the website (either at the start of 2004, or the fund's inception date).

The most important point to note from the chart is not that the seven hedge funds in the portfolio generated similar returns to equities over the time period considered - we would not expect this to repeat often in the future, as history has shown that equities have generated the strongest returns of all classes over the very long-term.

What is most important to note is that the returns from hedge fund portfolio were considerably smoother than the returns delivered by the equity portfolio. In fact, the seven hedge funds in the portfolio never - collectively - experienced a single down year from 2004 to 2014, while the equity portfolio experienced two down years in 2008 and 2011. Readers should note that not all hedge funds achieve this - as we noted in the previous section, the HFRX Global Hedge Fund Index declined along with the FTSE World Total Return Index in 2008; an investor needs to pick hedge funds that he/she believes are managed by a team with a good understanding of the risk inherent in investing and a robust strategy for managing portfolios. We believe the seven funds that we have picked possess these characteristics.

Overall, the hedge fund portfolio delivered 77% less volatility than the equity portfolio without reducing the returns. While we would not recommend that an investor have 100% exposure to hedge funds - as equities have historically delivered the best returns of all asset classes over the very long-term - even including a 20% allocation to the seven hedge funds that we cover (and thus an 80% allocation to equities) would have reduced volatility by 18% without sacrificing returns.

Thus we can say that, insofar as volatility is a good proxy for risk - which is true for investors who need to draw on capital in the near future, or who have a low risk appetite - hedge/absolute return funds are useful in portfolios for reducing their overall risk.

Members of our website have access to the list of funds that make up the above portfolio of seven hedge/absolute return funds, and all the ancillary information required to purchase them into a stockbroking account, be that an online, low-cost stockbroking account or a traditional full-service, higher cost stockbroking account. 

This article was written by Darren Gillen, an investment analyst with GillenMarkets.com, the online investment website.