It has become a cliché to say that not all hedge funds are the same. Nonetheless, it remains the community's greatest problem. The fragmented structure of the market is in part due to the specialist nature of the investments, combined with the mystique and secrecy surrounding the mechanics of it all. It's the investment management equivalent of freemasonry.
That mystique, combined with a seemingly disastrous last half of 1998, at least in public relations terms, is undeniably harming the industry. According to fund of hedge funds manager Michael Goldman: Some investors are beginning to entertain severe doubts about the quality of the hedge funds sector as a whole." The $35bn redeemed from hedge funds at the end of 1998 was no more than was expected, but it probably discourages other investors from taking advantage of the opportunities now becoming available. The best investment opportunities for institution-friendly hedge fund managers, the market-neutral and event-driven situations, are all in the US, and that is where the vast majority of hedge fund investment by pension funds, endowments and foundations ha s taken place. In Europe, the market may change quite fast over the next few years, but right now there is not much meaningful 'alternative' investment going on. Large pension portfolios run by the likes of Nestlé and ABB are looking at investments in real estate and natural resources such as forestry - what are known as 'hard assets'. But because of uncertainties about risk measurement, portfolio monitoring and fee structures, progress has been slow.
So, with all this going on, why would a European institution, used to investing in traditional assets, embrace the hedge fund idea within its portfolios? It might be tempted, if it could be demonstrated that the risks were not as great as many fear. Indeed if it could be shown that because of the non-correlated nature of the investments, use of hedge funds could actually enhance risk control, the European market would develop at a faster pace than hitherto. Can the concerns of traditional investors with regard to risk be allayed? "Many people may wonder whether hedge funds have collectively grown so large, and their positions so venturesome, that they are a source, rather than a mitigator, of systemic risk," says Stephen Lonsdorf, president of Van Hedge Fund Advisors in the US. "We estimate the global hedge fund industry manages approximately $300bn in unleveraged equity as of the end of 1997.
That is not a significant amount when compared to the level of capital in the global financial markets."
So hedge funds are not to blame for almost bringing about world economic meltdown last year. But Lonsdorf concedes that they do have an inherent element of risk that is not present to the same degree in many other investments, such as mutual funds: "That risk is the future use of bad judgement by the fund manager in such areas as portfolio concentration, leverage and/or liquidity. Further, that particular risk is not measurable as, by definition, it relates to the future. For example, many hedge funds use large amounts of leverage, and the risk control of the fund's leverage is often totally dependent, from moment to moment, on the judgement of its manager. While the history of hedge funds overall has been good in this regard, there have been occasional hedge fund failures." In other words, past performance is absolutely no guide to the future. Looking at the investment returns - 20-40% a year, every year, for the adventurous, often leveraged, investor; 12-15% for the more cautious - it is easy to see why institutions, disappointed by the marginal performance of traditional portfolios against their benchmarks, might be tempted to look at these alternatives.
William Miller of the Common Fund, in Connecticut, says he tends to put alternative investment into two distinct categories. The first, comprising more liquid and volatile assets, includes long and short stocks, bonds, short-term cash, energy derivatives, real estate investment trusts, currency overlays and managed futures. The second category, comprising less liquid and less volatile assets, includes venture capital, distressed debt, long-term arbitrage, oil and gas, and real estate.
Academic research has shown that hedge funds offer an attractive opportunity to diversify an investor's portfolio of stocks and bonds. This is true even if the returns earned by hedge funds in the future are merely on a par with stocks and bonds. "We do not need to see risk-adjusted returns as high as they have been in order to justify diversifying into hedge funds," says Lonsdorf.
US professors Tom Schneeweis and Richard Spurgin have conducted studies which demonstrate that traditional portfolios can be enhanced by the use of hedge fund vehicles. Among the conclusions of their research, they maintain that traditional approaches to asset allocation for stocks and bonds can also be used to determine suggested allocations to a wide range of alternative assets. The eternal conundrum for the hedge fund managers trying to break into the pensions market is how to create an index of alternative investments. The hedge fund community has tried and failed to come up with a meaningful benchmark. As Financial Risk Management's Blaine Tomlinson explains: "A passive index of hedge fund performance is not as valid a comparison for a hedge fund manager as it is for a traditional manager.
However, alternative means do exist for determining whether or not managers have added value. Performance benchmarks should include absolute return comparisons (90-day T-bills or Libor plus a premium, or a fixed positive return) and relative comparisons (sector or peer group). They should also include risk benchmarks, using either a downside deviation or standard deviation, and possibly also a maximum drawdown."
Another major problem with hedge funds is their lack, not just of transparency, but visibility. The range of funds is not well represented in the press, and although there are plenty of funds that have been unaffected by the Russian and Asian crises, no one hears about them. Equally, many supposedly market-neutral funds have been exposed as being anything but. Some will be forced to close. With so much of the distribution of hedge funds being offshore and private placement, the mechanism for countering the bad publicity is not that well developed.
After August 1998, it can't have been easy to be selling the idea of hedge funds. Even someone as omniscient as George Soros, who had warned of the imminent collapse in Russia, was powerless to prevent his own funds losing billions of dollars. This is not likely to inspire much confidence in the stability of hedge funds. In many ways, the Long-Term Capital Management debacle was just further proof of what everyone already suspected: the hedge fund managers are not as indestructible as they like to make out. As Sohail Jaffer, chairman of the Alternative Investment Management Association comments: "It has been somewhat difficult in practice to deliver positive returns in good markets and bad", which is the one claim the absolute return managers make that differentiates them from traditional long-only portfolio managers.
The role of consultants is crucial in guiding the investor to an investment mix that matches his risk/return profile. According to Jaffer, "leading consultants impress upon investors that this is one of the greatest potential risks that awaits them. Comprehensive due diligence must have been completed on both sides and investment guidelines agreed." As Miller of the Common Fund puts it, "A little scepticism is healthy. There is no such thing as a stupid question when it comes to alternative investments. One is well-advised to perform thorough research, not only on the investment strategy but also on the detailed mechanics of how a contemplated alternative investment is to be implemented."
Miller says that for investors wanting to integrate alternative investment strategies into their portfolios, there are two main model sets: "One is very simple, it involves dividing a portfolio into two categories - traditional and non-traditional - and making an allocation based on economic and risk characteristics, as well as on the time and resources needed for effective management and monitoring of the activity. This approach allows investors to add alternative investments that have the potential to add incremental value with an understandable risk that diversifies the overall portfolio. "One has to recognise that the investment process is dynamic and evolutionary: new products and strategies are developed on a regular basis. Having a structure that devotes, for example, 80-90% to traditional investment and 10-20% to non-traditional investment, gives investment professionals flexibility to alter allocations in a dynamic investment environment."
The other main model set for alternative investors involves developing target allocations, with ranges for each type of traditional and alternative investment. For example, a portfolio framework could be defined that allocates A per cent to domestic stocks, B per cent to venture capital, C per cent to international stocks, D per cent to emerging equity, E per cent to distressed debt, etc. Miller comments, "This model defines each activity and, depending on one's perspective, is either more rigid or more disciplined than the previous model. These two models can be viewed as defining two broad perspectives. Investors can gauge their own understanding and experience, and may choose a hybrid approach somewhere between these two." The strategies are not new: insurance companies, endowments and other institutional investors have invested in private debt, private equity and derivative strategies for years. What has changed is that when these large, diversified investors took losses in a particular product, they were often hidden by gains in other areas. For a single hedge fund, lack of product diversification heightens its risk, but does not necessarily increase the risk of its investors, who should be well diversified across a number of hedge funds and a number of asset classes.
The irony of LTCM was that this was far from the case. The fund of hedge funds solution offers institutions a more manageable way of utilising absolute performance strategies. The hedge funds study carried out by Financial Risk Management in 1998 showed that a basket of hedge funds, typically using market-neutral and event-driven styles, did produce better performance overall. Bankers Trust has a successful fund of hedge funds, using a categorisation and modelling service developed in the US. The key to its success, says a spokesman, is that for no more risk than a bond, you get a return closer to that of an equity. Hedge fund umbrella specialists such as Momentum also saw substantial inflows during the first half of 1998, reflecting a growing acceptance of their absolute performance pedigree. Using reference sources such as MAR and Tass, it is possible to assess those funds which have produced consistently high returns, with commensurately low Sharpe ratios. While the hedge fund industry continues to claim "you can't ignore us", the issue of fees remains hotly disputed.
Managers say they can justify the high fees because they produce the performance and besides, they need to employ the best brains in the business. The industry standard used to be one and 20, but now, says one observer, "some managers have got greedy and are charging two and 20 - and now they are talking about lock-ins as well. Is a pension fund trustee going to agree to be locked into something for three years, when they don't know what they are invested in?" The hedge fund sceptics maintain that the sophisticated portfolio management adopted by many institutions means there is little need for the use of hedge funds. "The skill strategies - high-yield debt, leveraged buy-outs, arbitrage etc - highlighted by many eminent commentators are simply not being used, and it is hard to see many pension fund trustees being able to countenance their use," says one hardened sceptic.
AIMA's Jaffer suggests that "with DC coming in, the investor is carrying the risk, so it will be easier to incorporate alternative investment into a pension fund. You will be able to allocate up to 5% of the assets into specific intelligent strategies." There is no doubt that the question of whether or not hedge funds have a place in the European institutional portfolio will continue to be furiously debated."

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