Secrets of Success: Hedge funds may yet confound critics

Having written some not so enthusiastic articles about hedge funds in the past couple of years, it seems only fair to acknowledge that the theoretical arguments for having some kind of hedge fund exposure in your portfolio are perfectly sound.

Having written some not so enthusiastic articles about hedge funds in the past couple of years, it seems only fair to acknowledge that the theoretical arguments for having some kind of hedge fund exposure in your portfolio are perfectly sound. It is a truism to say that adding a small chunk of an absolute-return fund which displays a low correlation to the stock market must improve the risk-return profile of an overall investment portfolio.

It follows from the nature of the beast and would be equally true of any other investment class that happened to share the same low correlation characteristics. One of the doubts about hedge funds is whether they can maintain those characteristics, now that so much more money is flowing in their direction. The correlations of the past may not repeat into the future. If they do, well and good, but that is something that can only be tested empirically.

Nevertheless, given the attractions on paper of the hedge fund concept, it is no surprise to hear Marc Gordon, managing director of Close Investments, say that he is surprised by how hostile a reaction the idea of hedge funds has received in the past couple of years.

The argument that Mr Gordon and other hedge fund proponents make is that the hedge fund concept is here to stay, and that those who pooh-pooh the idea are liable to look foolish in a few years when everyone, down to the most inexperienced investor, will happily put at least a portion of their savings into some kind of packaged hedge fund product. If that does take place, the most likely route is through a rapid growth in funds of hedge funds, which bring together a range of different hedge fund styles and personalities, and offer greater diversification potential, albeit at the cost of yet another layer of fees.

I can see this may be what will happen. Close Investments has been clever in recent years in coming up with ideas for specialist funds that break new ground. Its most recent hedge fund offering is a guaranteed fund of hedge funds that offers 100 per cent protection of capital, while giving exposure to a range of different hedge fund strategies run by the Man Group. The fund is targeting an annualised return of 11-13 per cent, with volatility of seven to nine per cent.

In marketing terms it may well be onto something with this kind of innovative product. Introducing a capital guarantee should make it easier for sceptical investors to come to terms with the otherwise daunting prospect of having to discover what exactly it is that the hedge fund you have chosen is going to do with your money.

But what intrigues me more is whether some courageous fund provider will in time go further and actually guarantee for a period the returns of the fund itself - in other words, say to investors: "Look, we think this is a great product, so much so that we guarantee we will underwrite a minimum level of annual return over, say, a five-year period." If absolute-return hedge funds are such a sure fire thing, there should be only a limited downside in such a promise.

Such a guarantee would address the main concerns that many private investors have about hedge funds: that they are too expensive, too secretive and too inaccessible. And yet we know that a low-risk, absolute-return product - which is what a fund of hedge funds should be - is exactly the kind of thing that many ordinary investors want. It is, after all, exactly why with-profits funds and bonds were so popular for so many years.

But I feel that a guaranteed-return hedge fund product will not appear on the investment radar screen soon. The reality, now documented in academic studies, and acknowledged in the Close Man prospectus, is that the historic risk profile of hedge funds is subtly different from what it first appears to be. Most have "long-tail" rather than normal distributions. While they may show consistent small but positive returns over several years, they are liable to suffer a rare but much larger fall once every so often.

Giving guarantees that seemed innocuous at the time but which proved noxious in the end was the straw that broke the back of the with-profits fund industry. A guaranteed-return hedge fund product would be worth buying, and one can see some large provider convincing itself that it would be worth providing. But it may end in tears.

The other generic problem that hedge funds face is that while their record of slow but steady returns looks good in the wake of a bear market, it is not clear why paying three per cent a year in fees should be good business in a low-return environment. That said, it seems more people will go down the hedge fund route for a while yet.

jd@intelligent-investor.co.uk