This article is intended to provide the background for family business owners or family office investment staff considering investing in hedge funds.
The hedge fund landscape: background and definitions
This term is subject to misunderstanding and confusion. The term 'hedge fund' is generally understood to refer to limited investment partnerships that cater to institutions and high net worth individuals or families. Hedge funds are allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, programme trading, swaps, arbitrage and derivative. They are restricted by law to less than 100 investors, are managed by a general partner who usually receives performance-based compensation and have a high minimum investment requirement, often US$1 million or more.
There are over 5, 000 hedge funds, by most reckonings. The majority of them are small, with less than US$50 million in assets. The largest are in the US$10 billion to US$15 billion range but are relatively few in number. Most of the US$400–500 billion managed by hedge funds these days is concentrated in two of the many styles or strategies: long/short equity and market neutral. Other popular strategies include convertible arbitrage, merger (risk) arbitrage, fixed income arbitrage, global macro, managed futures and distressed securities. There are various sub-styles within these.
Fund of funds are popular as well, especially for investors who balk at developing the resources to select their own managers and then continuously oversee the multi-manager portfolio, recognising that this is not a job for parttimers. In principle, fund of funds are analogous to mutual funds or unit trusts, but in this case they are selecting hedge funds rather than individual stocks. Some fund of funds specialise in a certain hedge fund style, investing in, for example, a portfolio of long/short equity managers with a variety of sector and geographic concentrations. The challenge in fund of fund investing is to identify one that can truly add value to the investment process, since there is a second layer of fees to contend with.
Hedge fund management
Broadly speaking, there are two approaches to managing a hedge fund:
- Arbitrage strategies that seek to exploit pricing inefficiencies between assets with similar characteristics.
- Long/short strategies, in which managers seek to exploit changes in market valuation of selected assets.
For hedge fund managers, shorting stocks and bonds is often an essential part of their investment process. Shorting a stock, for them, is not simply a matter of identifying weak fundamentals in the company. Some managers require a catalyst that he or she believes will trigger a meaningful decline, perhaps even independently of an overall equity decline.
Many managers of long-only portfolios at traditional investment firms have crossed over to the realm of the more flexible and potentially more financially rewarding risk-averse world of hedge funds. This is one of the reasons for the large increase in the number of hedge funds. Hedge fund managers in the popular imagination are unlikely to be risk-averse, but the reality is that an overwhelming majority take their risk management responsibilities very seriously. Shorting stocks is a complicated endeavour that can enable them to mitigate risk and stabilise the stream of returns relative to the long-only manager. Although the occasional hedge fund blow-up dominates the news for months after it happens, no matter what the cause, they are very much the exception.
Hedge funds have been around for over four decades, but the real growth has taken place since 1990. Just a few years ago 40% of industry assets were in global macro funds, like those run by the famous George Soros, but those funds and many smaller counterparts were beaten down during the technology crash. Substantial assets have shifted to long/short equity style, in which there are new managers almost every day, especially in Europe, leaving global macro with a much smaller slice of the pie. As in every other aspect of life, styles and fashions change over time. The hedge fund world is no different, though here the changes are driven by returns rather than taste.
Asking the right questions
A difference between family business owners and other investors is that family business owners may have a large percentage of their net worth committed to their own enterprises. This can make the effort to achieve diversification using hedge funds somewhat more complicated. The business owner, unlike most other investors, will have to determine the degree to which the value and/or returns of his or her business interests are correlated with equity markets before being able to judge how much and what kind of hedge fund exposure will provide the needed diversification.
Many investors enter the hedge fund arena for diversification that they hope will translate into downside protection. But others primarily seek high returns, believing that hedge fund managers are more aggressive than traditional managers and will outperform them. It is true that in many years, including 2001, many hedge funds outperform traditional equity managers and indices. This is not necessarily because they are more aggressive, but because their status as unregulated entities allows them to employ their skills more freely and flexibly.
The investor should decide which of the following three paths, either independently or in combination, to take: using a consultant; investing in a fund of funds; or doing manager selection and investing directly oneself, with no guidance. This decision will be driven largely by whether the investor wants a passive or active role in the investment process. His degree of involvement will vary greatly depending on which of these approaches he takes. The investor must also be clear about what his objectives are – downside protection or relatively higher returns than are generally available from longonly investing.
Hedge fund investing
Using a consultant makes sense for some investors, and there are many to choose from. The search for the appropriate consultant requires hard work of an investor, but the approach allows investors to find a balance between investing in a fund of funds, in which the investor has no decision making authority concerning the managers to be included, and investing directly, in which the investor would have complete control. Working with a consultant, an investor can, if he wishes, have direct access to managers during the selection process and can have input into the process. Consultants can provide objective advice and can often provide the quantitative screening that many investors value and they should have the relationships with managers, prime brokers, and marketers that expedite the investment process.
Investing in a fund of funds is appropriate for investors who prefer to delegate the manager selection and portfolio oversight to a professional who (one hopes) has the necessary skills, experience and resources. The investor, of course, must be willing to pay a second layer of fees over and above the individual manager fees. An advantage using a fund of funds is that it may be able to provide access to certain 'closed' managers, those who are not accepting new investments. Some of the long/short equity managers who opened in the last few years closed in record time, leaving many interested individual investors standing on the sidelines. With more institutional assets chasing the popular managers, individual investors can be left standing on the sidelines. The high minimums required by most hedge funds is another reason some investors find funds of funds appealing.
Investing directly in individual managers is by far the most challenging and time-consuming approach, requiring an entrepreneurial spirit, which family business owners possess, of course. But this should not be undertaken without substantial preparation. Direct investment requires knowledge, skills, relationships with managers, prime brokers and perhaps third party marketers, resources, a hefty travel budget and a strong stomach. One might think that travel would not be necessary since managers would 'come to you'. But it's essential for investors to visit a manager in the manager's own office at least once to get a feel for the operation; the way a manager runs the business aspects of the fund is crucial to assess. An advantage of the direct method is that it protects you from subjective biases that a consultant or fund of funds manager may bring to the process, though in certain cases these biases could be useful.
Whichever approach a family business owner chooses, the rewards from investing in hedge funds can be substantial, measured in terms of lower portfolio volatility and higher risk-adjusted returns. But the extensive preparation and education necessary to understand this alternative investment area must not be neglected.