Don’t fire your all-star team just because they didn’t win last season’s championship

September 06, 2013  

By Dixon Boardman, founder and CEO of Optima Fund Management

  Dixon Boardman
I have been investing in hedge funds for more than 25 years. Through thick and thin, they have served my long-term objectives of preserving and growing my capital very well, especially when conventional markets have been so very volatile. I am therefore planning to continue to invest in hedge funds for the next 25 years.

Do I invest all my money in hedge funds? Of course not. But having a good-sized portion of my assets in alternatives has served as a very effective diversifier and risk reducer over time.

Do hedge funds always outperform conventional investments? Of course not. But historically they have added value. And, to reiterate my earlier point, I certainly sleep better at night knowing that I have hedge funds as part of my overall investment programme, rather than tossing and turning with worry about the market’s roller-coaster ride.

Many wealthy individuals and family offices have been disappointed by the performance of hedge funds over the past five years. Many of these investors recall an earlier time when hedge funds delivered higher returns. Because hedge funds as a group have lagged the S&P 500 since the global financial crisis, private investors are increasingly questioning why they should bother with hedge funds, or they are voting with their feet and scaling back their investments.

In contrast, many institutions, including some of the most savvy pension funds and endowments, actually have been steadily increasing their allocations to hedge funds over the past five years, because they understand three important benefits of alternatives:

• Historically, hedge funds as a group have outperformed on an absolute or risk-adjusted basis, even after factoring in their recent results.

• Unlike long-only managers, hedge funds as a group are less volatile.

• Hedge funds as a group tend to be less correlated with conventional markets, and thus can help dampen the volatility of an overall investment programme.

J.P. Morgan’s prime brokerage unit recently published an in-depth research piece about hedge funds. Its analysis provides a very clear-eyed view of how hedge funds have done. To summarise its findings:

• "In the first quarter of 2013... in the aggregate [as measured by the HFRI Fund Weighted Composite Index] hedge funds trailed the S&P 500 by 6.74%…"

• "The HFRI Fund Weighted Composite Index… underperformed the S&P 500 Index by nearly 5% annually from 2010 through 2012. This pattern reflects the run-up in equity markets as they rebounded from their post-crisis lows, receding tail risk as the sovereign crisis in Europe eased and gradual improvements in economic data."

• "Over a longer time period, however, a different picture emerges. During the 16 years from 1997 through 2012, hedge funds delivered superior cumulative returns to domestic and international equities, commodities and fixed income by substantial margins:

HFRI Fund Weighted Composite +225.19%

Barclays Capital US Aggregate Bond Index +161.48%

S&P 500 +92.54%

MSCI AC +68.38%

DJ-UBS Commodity +13.95%"

That wasn’t just any old 16-year period in which hedge funds outperformed – it was a period marked by extraordinary market ups and downs, including the tech bubble, Y2K and, of course, the global financial crisis. We don’t know what the next 16 years will bring, or even the next 16 months for that matter. But we do know that the potential for market dislocations and corrections is ever present. If you are convinced that markets will go up in a straight line from here, then long-only investment approaches are for you. If you appreciate the potential for volatility, hedge funds can be a useful part of your asset allocation plan.

Consider one more thing. Think back to the depths of the global financial crisis and the subsequent heights of market anxiety over Greece, Europe, and the downgrade of US debt. Very few investors had the stomach to jump into equities at those points in time. In fact, many were so shaken that they sold at what proved to be the worst possible time to do so. One advantage of allocating to hedge funds that are less correlated is that it becomes easier to ride out the storm.

Throughout my career of investing in hedge funds I have always sought out what I believe to be the 'all stars’: seasoned pros who have demonstrated their ability to add value over time and to avoid the worst of the market downturns. My team also includes the 'rising stars’: not amateurs or farm league players, but well-trained talents who have gained valuable experience at established firms and have generated strong track records in their own right. My 'all stars’ and 'rising stars’ might not be the champions every year, but their winning record and potential going forward gives me the confidence to back them season after season.

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