Searching for function in the face of futility
Q1 – Quarterly Commentary
“If there is anything that links the human to the divine,
it is the courage to stand by a principle when everybody else rejects it.” – Abraham Lincoln
Many global capital allocators and investors have bemoaned the extent to which traditional asset classes have correlated over the past seven years. Central bank intervention has led to bonds rallying at the same time that equity markets do, and vice versa, reducing the benefit of a diversified portfolio. Investors have consequently started thinking about looking elsewhere for diversification and returns.
The search for returns which are uncorrelated to traditional benchmarks often lead to alternative asset classes. However, if popular media is to be considered the authority on hedge funds, then not only should they be excluded from a prudently diversified portfolio, but the principals of these hedge funds should be burnt at the stake for the flagrant disregard of their fiduciary responsibilities. After all, Warren Buffett predicted (at the bottom of the equity market crash of 2008) that the S&P 500 Index would outperform a range of five fund of hedge funds over a period of 10 years, and it is on track to do so. Furthermore, a focus on the personal success of some businessmen, who happen to be hedge fund managers, by the mainstream media, makes the obvious case that hedge funds are bad for investors. So if the media says it, and Warren Buffett the second wealthiest man in America says it, it must be true. Abraham Lincoln’s quote above reminded me of a less well known saying which states that we cannot allow our views on vitally important issues to be shaped by the pressure of popular opinion. So, do we subscribe to this view of the futility of hedge funds, or do we critically search for function in the face of this futility?
I don’t believe that this assessment can be done without the context of costs versus value when it comes to active management fees, and would thus remind you of our commentary on this subject entitled “Not all investment fees are equal”. (For those who would like to read this, it can be found here: https://fairtree.com/blog/not-investment-fees-equal/ )
When I was a teenager my eyesight was quite bad, with my astigmatism only rectified by means of Lasik surgery in my mid-thirties. Anytime I removed my spectacles or contact lenses, it seemed as though I was looking at the world through petroleum jelly glasses. Hedge fund strategies by their very nature are more complex than traditional asset classes. A combination of leverage, shorting and other seemingly complex financial concepts seems to have the same effect as the petroleum jelly, blurring one’s view on the efficacy and functionality of these strategies. I think it is useful to practically unpack some of these key concepts before looking at the applicable functionality of hedge funds within a diversified portfolio.
Let me first attempt to explain the concept of short selling. Traditional long only portfolios can only derive returns for investors by buying securities which increase in value. Securities which fall in value either detract from returns or, with perfect foresight, are avoided by the fund manager. Investors can however profit from securities which fall in price through the concept of shorting in a hedge fund. Shorting, when done successfully, involves selling a security at an elevated price, and then buying that security back after the price has fallen. Needless to say, various mechanisms significantly less complex than the inner workings of a bank or an insurance company, facilitate the ability to short sell a security which is not owned by the portfolio in order to profit from the falling prices. A stylised example would be if I borrowed your Kruger Rand to deliver to a buyer with whom I agreed a price at which to sell the Kruger Rand. The value of the Kruger Rand falls, to which I respond by buying one back in the market, and subsequently return it to you. For the use of your Kruger Rand, you may charge me a small rental, but provided my sale and purchase prices generated sufficient profit, I should be more than happy to pay you a small rental. That’s shorting…..in a nutshell.
Let’s talk about the concept of leverage. If you currently live in a home which you have purchased with a combination of a deposit and a bank mortgage, you already understand and embrace the concept of leverage. In fact with a 20% deposit, you may already be comfortable with a level of 5 times leverage or 500%, because you are now a proud owner of a property valued at 5 times the capital you had at your disposal. Although long only funds are not permitted to deploy this same type of financial engineering which most of us easily exploit, hedge funds have the freedom to do so. Interestingly, most hedge funds are considerably more conservative than the property owner described above, deploying somewhere between 2 to 3 times leverage or 200% to 300% in exposure terms. So I believe the scaremongering of the media with regard to leverage within hedge funds is largely overdone. Of course one has to be prudent with regards to who you select to manage your hedge fund exposure and ensure that investment restrictions limit the excessive use of leverage. But, by and large, that risk is overstated in the South African market with hedge funds regulated by the Financial Services Board under the Collective Investment Schemes Control Act, in the same way that traditional unit trust investments are.
So now that we understand that these financial concepts are not that daunting, let’s try to frame the functionality and application of hedge funds within a diversified portfolio. One of the most common mistakes I see in this regard is that investors think about hedge funds as a homogeneous group. This cannot be further from the truth. Applying the tools available to skilled hedge fund managers can result in many very different outcomes. In the South African market, I believe we can group hedge funds into two broad buckets irrespective of the style of the fund or within which asset class it is expressed. Within a multi-asset portfolio, hedge funds can either be diversifiers or substitutes. Diversifiers act to compliment an investor’s existing portfolio by adding relatively uncorrelated building blocks to the portfolio. This in turn acts to reduce portfolio volatility and enhance risk adjusted returns. These diversifiers thus do not exhibit a dependence on market returns in order to generate positive excess returns for investors.
Substitutes, however, are a group of hedge funds which look and feel more like their traditional asset class counterparts. When comparing these funds to their long only cousins, they look like muted versions of the same thing. So a long short equity fund could behave in a similar fashion to an equity long only unit trust portfolio, with the exception that it minimises some of the downside, giving the investor a bit of a smoother journey. This reduction in volatility also enhances total risk adjusted returns on the overall portfolio.
Needless to say, comparing the nominal returns of a diversifier to a market index after a period of strong performance by that index is futile. The intent was and should never be to outperform the index, especially in robust performance periods, as this would inevitable imply a strong dependence. It would further imply Utopia, if one were to suggest that diversifiers should perform in all market conditions. Diversifiers certainly present portfolios with the opportunity to reduce reliance of the market in order to outperform risk free yields, and should be considered in this context. With most South African portfolios being highly exposed to equity market risk, it makes sense to consider diversifiers which have very low to negligible exposure to equity markets. Seeking out managers who extract returns in adjacent markets such as fixed income markets, commodity markets or a combination thereof will enhance the probability of identifying a true diversifier.
Substitutes will produce returns which are more muted than the market index in which they operate. Their application should thus be considered alongside an allocation into that asset class. Hence if a portfolio holds large exposure to equity risk, this could be muted by allocating to a range of equity long short hedge funds. The exposure to equity risk will be marginally reduced (based on the degree of market exposure in those substitutes) without losing the original intent of market correlation and dependence. Investors would have to seek out managers who best reflect the degree of market exposure they are wanting to maintain, in each asset class in which a substitute is being considered. Investors would then have to calibrate their returns expectations for those substitutes accordingly.
Hedge funds are definitely not the panacea to all investment woes. Utility can only be determined once the investor has clearly defined the rationale and function for the hedge fund allocation. As a broad framework, thinking about them as either diversifiers or substitutes, adds a degree of simplicity when evaluating the success of such an allocation. By definition, diversifiers are potentially very different to traditional asset classes and possibly more complex, requiring greater effort by investors in their due diligence processes. When a true diversifier is identified it has the potential to reward investors for the extra effort required to evaluate them. The increased complexity can be a hindrance to investors, and thus most look to use substitutes. Finding a diversifier which can compete with nominal market index returns over time remains the most favourable outcome for investors who do not object to significant performance deviation from the index in the short term. These results may only be appreciated over a multi-year evaluation period however.
Nonetheless, for South African investors, finding a relatively high performing diversifier with low beta and low correlation to the South African equity market, should be an extremely attractive proposition.
Chief Investment Officer