EUROPE - Hedge funds were the victims of the financial crisis and not the perpetrators, and they remain an appropriate tool for institutional investors, argued Francois-Serge Lhabitant at the 12th Uhlenbruch Annual Portfolio Management Conference in Frankfurt.

The CIO of family office group Kedge Capital and professor of finance at EDHEC Business School (pictured) pointed out that hedge funds outperformed equities in 2008, and over three, five, 10 and 20 years. Over 20 years they have given twice the return with half the volatility of equities, and their maximum drawdown of 25% is half that of equities.

Only 69 hedge funds have 'imploded' since late 2006, he observed - far fewer than the number of failed banks. Many of those banks entered 2008 leveraged 15-30 times (Lehman Brothers was geared 100 times at the point of bankruptcy), while hedge funds were geared only 1.4 times on average in aggregate.

Rather than being the source of systemic risk, hedge funds were victims of a flight to cash and 'pre-emptive' redemptions that set off forced unwinding of assets, claimed Lhabitant.

Nonetheless, he conceded that the industry had grown bloated with mediocre managers in the years leading up to the crisis.

"It has increasingly become a fees business," he said, "while the only way to satisfy excessive client expectations has been to take on more beta and directionality."

These are issues for the market to address rather than regulators, he suggested: "Those who failed in regulation want to expand their regulatory powers. Regulation is good, but it needs to be refocused on protecting investors and the financial system."

On transparency, Lhabitant added: "Before investing with a hedge fund I make sure that the level of transparency I will get matches my needs. It is up to investors to dictate these terms. No-one is forced to invest in any fund."

Similarly, he argued that investors should focus more on 'the money in their pocket at the end of the day' than absolute levels of fees. If an investor in a traditional long-only active fund disaggregated the share of its 1% management fee that was being spent on the (tiny proportion) of active risk, it would be more like an 8% fee, he claimed.

"The highest fees I've ever seen for a hedge fund were 4% and 44%," he said. "We had to exit that fund because the manager no longer wanted to share his capacity. I would have stayed in if I could, and it would have been the best allocation of my life."

Investors should continue to allocate to hedge funds, Lhabitant argued, but the way they allocate should change: rather than deciding on a proportion of the portfolio to put into hedge funds as an asset class, he said that they should regard them as active exposure to existing asset classes, and that the optimal proportion to be allocated would therefore be a function of how much active risk an investor wanted to take across its entire portfolio.

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