|07 April, 2019

Hedge funds: Managers promise market-beating returns, but watch out for those fees

Intended to provide protection against market risks, in the past decade hedge funds have fallen out of favour. But with fears of a correction in equity markets on the cards, should investors reconsider?

Hedge fund managers and investors meet at the Context Leadership Summit in Las Vegas, Nevada, U.S., May 10, 2018. Image used for illustrative purpose only.

Hedge fund managers and investors meet at the Context Leadership Summit in Las Vegas, Nevada, U.S., May 10, 2018. Image used for illustrative purpose only.

REUTERS/Lawrence Delevingne

While hedge funds are sometimes thought of as producing high-octane returns through risky bets and lots of leverage, “that could not be further from the truth,” Jack Inglis, the CEO of the Alternative Investment Management Association, says. 

Compared with a typical long-only fund, hedge funds are less constrained in their investment mandates and can construct portfolios using leverage, derivatives, and the ability to short sell securities.

“[Hedge funds] seek to provide lower correlation to traditional markets and produce a greater unit of return for each unit of risk that is deployed,” said Inglis, himself a former hedge fund manager.

At the same time, hedge funds need to be able to beat the market, Zachary Cefaratti, CEO of Dalma Capital, a Dubai-based hedge fund management company, says.

“The primary goal of any hedge fund is to generate alpha, and alpha generation means that you need to be outperforming a passive, or cheap, exposure to an asset class.”

Nevertheless, hedge funds should be seen as complementary, rather than exclusive, to traditional investments, said Inglis. “In building a portfolio of investments, an investor should look to include hedge funds for the different exposures and different styles of investing that they offer.”

Who should invest?

While hedge funds are part of almost every heavyweight investment portfolio, the asset class has seen a decline in popularity over the last eight years or so, primarily because many funds have trailed their indices and so have been outperformed by passive funds, Alex Gemici, the chairman and CEO of Greenstone Equity Partners, a Dubai-based fund placement firm, says.

Hedge funds typically have higher fees than a mutual fund – fees that are necessary to maintain the high overheads of analysts and other investment professionals who craft and execute strategies. The classic fee structure is 2 and 20: a 2 percent annual management fee and a 20 percent performance fee, or carry, levied on the fund’s profits compared with a benchmark. 

The impact of fees has come more into focus as a result of the strong performance of passive funds, says Gemici. “Net returns have been problematic. Even if a hedge fund performs to the index, or slightly better, their net return to investors is below the index when their fees are subtracted.”

Nevertheless, Gemici says he’s seen a swing back to high quality hedge funds in recent years as investors have begun to ascribe greater value to liquidity. In asset classes such as private equity or venture capital, investments can be locked away for as long as a decade.

Hedge funds themselves have also become increasingly liquid, with the offering of so-called liquid alternatives– hedge funds offered in the UCITS and 40 Act Funds mutual fund wrappers. These allow investors to sell an interest in a fund more frequently than a traditional, Cayman-domiciled hedge fund, Inglis explains.

Investing in hedge funds is also becoming more accessible, with ticket sizes steadily reducing across the industry, he said. Some funds may accept investments as low as $5,000.

However, less experienced investors should take extra care when it comes to alternative investments, including hedge funds, says Stuart Ritchie, a director of AES International.

“Investments should only be made where the investor can fully understand the investment strategy. Quite often, alternative or hedge fund-type strategies may sound exciting but may not be appropriate for retail investors or suit their financial objectives,” he says.

Hedge funds in the Middle East

Total assets under management of Middle East-dedicated hedge funds is around $8.5bn, just a fraction of the $2.4 trillion of hedge fund assets under management (AUM) globally, according to figures from Eureekahedge.

And for most Middle East investors, hedge funds present an opportunity to geographically diversify their investment focus away from the region – and the correlation between asset performance and the price of oil – to global markets.

“Middle East investors we talk to generally have the view that they know their region, and they are more keen to see what opportunities there are outside,” says Mohammad Hassan, head analyst for hedge fund research at Eurekahedge.

Key interests for GCC investors are hedge funds with exposure to developed markets in North America and Europe, but there is increasing demand for investments in Asia, Hassan adds.

“Sophisticated investors [in Saudi Arabia] realise that there needs to be a balance on China, India, and even the rest of Southeast Asia, which has largely been ignored, but it’s a big story in terms of the demographics, the developments that are taking place, and the infrastructure yields that are happening,” he says.

Hedge funds can deploy a range of strategies, such as long-short equities, relative value arbitrage (where similar stocks or bonds with major price differentials are bought and sold at the same time), macro or event-driven. In emerging markets, GCC investors are keen to speak with managers who are running market-neutral or relative value mandates, while in developed markets, they are keen to speak with multi-strategy, multi-asset fund managers, says Hassan.  

“The thrust of it is that they want to speak to the managers who are less correlated to what is happening out there in the markets,” he said.

Beating a bear market

Comparing hedge fund performance in the Eurekahedge Hedge Fund Index, with the S&P 500 – using metrics such as the MAR ratio, a measurement of returns adjusted for risk, or the maximum drawdown of funds since inception – show that hedge funds offer slightly better returns with much lower risk over the past 12 years­. But if the return period were shortened to just five years, the S&P 500 has had better returns, with a similar MAR ratio, according to data from Eurekahedge.

How far back do investors’ memories go? While many have enjoyed high returns through passive funds in recent years as equity markets have surged – driven in part by the liquidity created by quantitative easing programmes – those with investments concentrated in ETFs could be exposed if there is a sharp market correction, believes Hassan.

For example, when the S&P fell by 40 percent in 2008, while most long-equity hedge funds fell by 20 percent, some hedge funds were up 20 percent, he says.

“If you do an overall analysis of hedge funds returns over the last 12 years, comparing the kind of returns they generated versus the downside protection that they have offered, it’s a no- brainer that you need to have a fair amount of your portfolio allocated towards these so you can participate in the upside of the market and have protection on the downside as well,” says Hassan.  

He says investors are sticking with hedge funds, despite their higher fees, because of growing uncertainty in global markets.

“Since 2013, a lot of money has returned to hedge funds, as investors are aware of what is happening in the financial markets: the liquidity that was pumped in, how it will be taken out of the system – it’s going to create a lot of distortion, and it’s going to affect a lot things. And it pays for investors to be in a strategy that is going to protect them, which is catered to perform better in down markets.”

Investors looking to make new investments in a hedge fund should look for funds that have produced positive returns – net of fees – in a down market, believes Gemici.

“I’d look at the last 5-10 years’ track record [of a fund], and I’d analyse their performance in a down market, how they have performed relative to a falling index.”

“If there is ‘negative alpha’, i.e. they fell more than the index, that’s a major problem. If they went down less than the index, that’s good. If they actually went up, or stayed the same, that is very good. What you want is a hedge fund that’s able to pick the winners even in a down market,” he said.

Sadly, the top performing funds­ – those that consistently outperform indices – are generally closed to new investors, noted Gemici. “It’s hard to get into the best performers.” 

(Reporting by Stian Overdahl; Editing by Michael Fahy)

(michael.fahy@refinitiv.com)

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© ZAWYA 2019