Why you can't ignore hedge space

"The Jones that Nobody could keep up with" is how Fortune magazine introduced Alfred Winslow Jones in 1966. He was news because his investments had provided a massive 44 per cent return in excess of the top mutual funds in the US. Jones is the father of hedge funds, and if you are going to ask, why didn't advisors tell us about these fantastic returns earlier, read on.

Jones has left an undeniable mark since his 'hedged approach' began in 1949; notably in introducing short sale as protection against market crashes in equities and against holding long, using speculative assets for conservative purposes; second, in introducing leveraging into portfolios, and finally, in introducing the concept of performance fees.

Despite Jones' success, the hedge universe had, by 1968, not really invested far outside of holding equities long and short, although the likes of Soros and Buffet were playing the game. In 1984, Tremont Partners identified only 64 hedge funds. This was a world of limited volume being run largely for the rich.

The 1990s, of course, produced a dramatic bull market so the need to find alternatives wasn't great. Nevertheless, Soros had started upsetting governments by making money on currencies, and Julian Robertson had begun to make money using derivatives. In 1999, Tremont estimated a 4,000 hedge universe.

Today, in 2003, a number of things are happening, which means that investors can't afford to remain too nonchalant about being outside of the hedge space; particularly if you have set absolute benchmarks for performance purposes and are looking for a steady return.

Today's world

First, this is a universe now of some 6,000 funds, and its leading indices described below under CSFB Tremont indicate returns superior to other traditional asset classes.

Second, the hedge space has now developed its own diversification through a wide range of management styles.

The macro-economic approach is one of the stars of the hedge world. Managers take a top-down view of global economic events and trends. They wouldn't be concerned about a particular company's recent invention, more bothered about the general trend on interest rates, inflation, and geopolitics.

For example, a current favourite of the macro guys is gold. In three months, gold could no longer be a trusted ally.

The emerging market scene is another popular area requiring specialist skill in asset classes of less developed economies. The strategy is usually defined by geography with little concern to asset class. The emergence of China, India and eastern Europe as potential short-term heavyweights, plus the significant rally in Asia this year, has brought this sub-class significant attention.

The income funds are a varied bunch. The Rand Merchant Bank Spread Capture fund has focused exclusively on managers running portfolios based on differences in yields and making money on different forms of debt. With a Standard Deviation of about 4 and returns averaging over 10 per cent per annum, this is going to appeal to those looking at positive absolute return benchmarks.
Distress profits

Distressed securities are a form of debt, in that managers invest in companies having financial difficulties. When the economic cycle is recessionary, it is difficult to persuade a bank to help your cash flow position.

Chapter 11 proceedings in the US, for example, provides opportunities for specialist teams of corporate problem-solvers to step in and charge a high yield for cash flow monies. The Pioneer Momentum range of funds provides examples of funds making hay from this activity.

Naturally, a lot of hedge funds revolve around equity strategies. Aggressive growth strategies generally imply that managers buy or sell equity on a momentum basis. If the market is moving up on a stock which they like, the manager will buy, as the market tends to do what it was doing yesterday. They will get caught out from time to time, but the trend in markets is usually greater than short-term volatility. This factor drives the managers thinking.

Special situations wouldn't be too dissimilar in that it revolves around buying and selling equities. However, the reasoning is different, driven by special events peculiar to a given company, for example, corporate restructuring, mergers and acquisitions and so on. Opportunistic is a style focused on big picture opportunities.

As implied above, short selling can be described as a category in its own right. As markets have risen this year the short-sellers have floundered after making hay in the previous couple of years.

Main factor

Market timing refers to the risky business of moving assets from one asset class to another depending on events and circumstances. Gary Brinsons Report on US Pension Funds suggests that asset allocation influences performance by a factor of over 95 per cent, relegating trading and market timing to a minuscule influence.

Market neutral-arbitrage and market neutral-hedging are the other two main styles. The latter reflects the ethic laid down by Jones over 50 years ago while the former reflects the fast-growing style of managers picking diverse assets and playing the price differences between them in order to make money. The Quadriga Fund and AHL are two expert houses in this arena.

As clear as mud? Perhaps this is why vast majority of hedge fund investment is leaning to a several-strategies approach, leaving it to the manager of managers to examine the performance and volatility dynamics of the different styles and the different managers within each style.

It is a confusing and fast-changing landscape. Yet, while the top-end results remain where they are, the hedge space remains difficult to ignore.

The author is the managing director of Mondial (Dubai) LLC