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Morningstar Advisor Chat Transcript: A Clear-Eyed Look at Hedge Funds

Morningstar Advisor Chat Transcript: A Clear-Eyed Look at Hedge Funds

Morningstar Advisor, 06/07/2007

The following chat took place on June 6.

Jerry Kerns: Hello everybody. Let's begin today's live chat. I'm Jerry Kerns, editor of Morningstar Advisor magazine. In our first issue, we ran some articles that took a critical look at an investment vehicle that is getting a huge amount of attention today in the mainstream media: hedge funds. With us today are the folks behind those articles: Ryan Tagal, Morningstar's director of hedge funds, analyst Nadia Van Dalen, and analyst Dan Farkas. Hi guys, and thanks for joining us today.

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Dan Farkas: Hello, everybody.

Nadia Van Dalen: Thanks for having us.

Ryan Tagal: We're ready for your questions!

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CurtisC: For several years now, the cost of credit has been low and worldwide market liquidity abundant. As a result, demand has been strong--and volatility relatively low--for most asset classes. Hedge funds have certainly benefited from these trends. But have they generated excess return sufficient to offset their typical much higher fees and sometimes much greater risks? Can you quantify your answer?

Dan Farkas: Hedge funds have been in a very attractive environment for years, which I talk about in my article in Morningstar Advisor. Including not only low global interest rates, but also narrowing credit spreads, small-cap dominance, the value investing tailwind on the heels of the Nasdaq bubble bursting in 2000, and the emerging-market boon. These are all risk exposures that hedge funds have been known to frequent. Your point is well taken--there will certainly be future periods that are not as kind to the average hedge fund.

However, it is important to note that hedge funds are a diverse group. In fact, their returns are much more varied than those of mutual funds, and it is therefore less productive to talk about them as a group than it is for mutual funds. So, as to whether they are worth their higher fees, there is no blanket answer: some are and some aren't. That question can only be answered on a fund-by-fund level. To exemplify this point, I looked at the average 2006 return in the top decile of our hedge fund Equity Net Long category and compared that to the average return of the bottom decile. There was a difference of 5,700 basis points. The same exercise in the Large-Cap Growth mutual fund category yielded a difference of 1,900 basis points. The upshot is that manager selection is probably even more important in hedge funds, and it is harder to speak about them with broad strokes.

As for your question about hedge funds' "much greater risks." I can't wholly agree with your premise--although we would first need to define "risk." For a long-term investor  volatility can be an over-rated measure of risk. Anyhow, while a larger proportion of hedge funds have the possibility of extreme losses (one measure of risk) largely due to their higher use of leverage by some measures of risk  many hedge funds are less risky than mutual funds. For instance  a hedge fund that has a mandate of absolute returns aims to provide returns that are not correlated to investors' other assets (another measure of risk). Funds like this come in quite handy when needed most--when investors' other assets are struggling.

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KevinT: It's been said that the best hedge fund managers don't need or want additional investors and don't advertise. Since  their fund data is not public information, they must voluntarily submit it to Morningstar for inclusion in your database. One might therefore conclude that  your database excludes these "shy" superstar managers. Please comment.

Ryan Tagal: Since we've started our hedge fund database over three years ago, we've worked hard to target the most elusive and secretive of hedge fund managers. These hedge funds generally have the most interesting investment styles, and our research team has strived to learn about the investment strategies and techniques they employ.

Yes, hedge funds voluntarily submit information to hedge fund databases, but we work hard to contact as many hedge funds as we can. We now have a staff of 10 individuals worldwide that are dedicated to reaching out to hedge funds.
We now cover about 8,000 hedge funds and funds of funds globally, which are collectively managing over $1 trillion in hedge fund assets. We also now track about half the hedge fund on seminal Institutional Investor list of the 100 largest hedge funds. The list of manager on this list are generally considered to be the movers, shakers and newsmakers in the space. Many hedge funds would like to avoid having draconian reporting requirements imposed on them by government regulators, so many of them are beginning to see the appeal in providing info to Morningstar.  We feel that in the long run, this and our effort we put into building our database will allow coverage and the quantity of info on this industry to grow to even the shyest of hedge funds.

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Charles: Often we were asked by our clients what is the Hedge Funds and is it good for them to invest in. There are any different view and  definition of hedge funds. Would you please tell me what is your definition of Hedge Fund?

Nadia Van Dalen: Good question, Charles! We don't have a definition of a hedge fund, and neither does the industry. To further complicate the issue, the definition of a hedge fund changes by geography. But here is my attempt at a definition.
Hedge funds are flexible, lightly regulated investment pools, with some key features: incentive (performance fees) in addition to management fees, high initial investments, and lock-ups. A hedge fund does not have to hedge-- it can be long only or it can use shorts not as hedges but as directional bets. Hedge funds are structured as different legal entities, catering to tax preferences and regulatory restrictions of the investor.

For the U.S. taxable investor, a hedge fund is usually structured as a private placement limited partnership. This is a flow through structure , where the pooled investments are taxed at the individual not fund level. The general partner of the limited partnership actively manages the investment pool for the investors, or limited partners. Because these funds are private placements, they are restricted as to the total number of investors (including number of accredited investors) and sales solicitations. They are considered flexible investments, not forced to stick to any asset class, investment strategy, or reporting schedule, except as detailed in the offering memorandum (which is usually pretty vague). They are not audited by any regulatory agency, with the exception of some commodity pools, and are not required to have independent financial audits, even though many do.
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JohnC: I need a basic discussion on hedge funds and their applicability to the small investor.

Dan Farkas: Every investor faces hurdles in the hedge-fund arena that don't exist to the same extent elsewhere (e.g., transparency issues, higher fees, higher minimum investments). These hurdles are even higher for small investors who want to invest in individual hedge funds. These investors typically do not have the same level of access to hedge funds (including the most exclusive hedge funds--think \velvet rope\" here) as institutions have do not have as much ability to invest huge sums in one bunch (potentially 8-digit sums)  and do not have the same resources to perform the kind of research that is required in this largely opaque field.

Furthermore, hedge funds are notoriously inefficient from a tax perspective--and unlike most hedge-fund investors, smaller investors generally invest in taxable accounts. If you can overcome the hurdles and become comfortable investing in individual funds, great. Otherwise, some alternatives to individual hedge funds are funds of hedge funds, hedge-fund indexes, and mutual funds that ply a hedge-fund like strategy.

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JoeF: I wish you all had an analyst report for Franklin Mutual Recovery FMRAX. Are there any other Event Driven multi-strategy alternative mutual  funds that you're aware of? Do you have any thoughts on FMRAX versus similar type hedge funds?

Jerry Kerns: Assuming that by event-driven you mean merger arbitrage, we cover Arbitrage Fund ARBFX, Merger Fund MERFX, and Calamos Market Neutral Income CVSIX.

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DavidJ: Have you studied the change in correlation between hedged funds and traditional equities?  It is my belief that the correlation of returns is much higher now than it had been, reducing any benefit in the vehicles.

Nadia Van Dalen: We have found that hedge funds have more of a small cap bias, so their correlation to the Russell is higher than that of the S&P. In terms of trends in correlation, I haven't found any looking over the last 10 years (not many hedge funds have data going farther back than that). I just looked at correlations of our Equity categories (Net Long, Variable, and Neutral) over the last 1,3,5, and 10 year periods ending March 31st. Correlations to the S&P 500 ranged between 0.73 and 0.78 for the Net Long, 0.61-0.71 for the Variable, and 0.22 to 0.56 for the neutral. Correlations to the Russell were  0.73 to 0.90 for the long, 0.74 to 0.86 for the variable, and 0.43 to 0.68 for the neutral category. So the correlation varies more widely in Equity Variable and Equity Neutral categories (more variation  within these categories), but I did not see any distinct rise or fall over time.

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RyanW: Are Hedge Funds highly leveraged?

Dan Farkas: Some are, some are not. We find that in large part this breaks down by strategy. The arbitrage strategies tend to take advantage of tiny mispricings and lever up the fund to achieve a return level (with corresponding risk) that investors desire. So convertible arbitrage, merger arbitrage, and fixed-income arbitrage funds tends to be highly leveraged. Those funds could be in the 5x to 6x territory. Equity long/short funds use much more moderate leverage. Some use no leverage at all, and most do not rise above 2x leverage.

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Jerry Kerns: We want to get to all your questions, so we're going to extend our chat past 4:30 p.m. We also want to know how we're doing. Please send feedback to magazine_editor@morningstar.com. Now, onto our next question.

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PeteS: Does Morningstar verify the data that the hedge funds provide?

Ryan Tagal: I can talk about our data collection process a bit. Morningstar does ask each fund whether the monthly return that they provide is an estimated, final, or audited figure. Most funds do provide audited figures at the end of the year.  Also, our process has business rules that require our analysts to check funds that have very large returns or losses, or that seem to be in error. In that case, the analyst will contact the fund again directly to be sure that they data we have on them is correct. However, since we do not physically visit every fund, on some level we depend on the hedge fund to be telling us the truth.

We have found that in the vast majority of cases, our automatic business rules have been very effective at finding errors.  We do try to detect fraud to the best of our ability, but have not found any funds guilty of that as of yet.

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TerryC: Can you recommend 3 or 4 key things to read that summarize the best research and analysis of hedge funds. I have seen a Barclay's report that was pretty good. Is there a book or review article?

Ryan Tagal: We think that Bill Fung and David Hsieh have done a lot of good research on hedge fund styles. Cliff Asness of AQR has an excellent paper called, "Do Hedge Fund Hedge." A quick Google search can help find these papers. Bridgewater Associates is a hedge fund that has published some interesting research on hedge fund styles.PAGEBREAK
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LeeA: Most hedge funds require accredited investors. Our firm manages portfolios for professional fiduciaries (trustees, conservators and guardians). They rely on us to protect their assets through careful diversification techniques we have developed. The non-correlation of hedge funds would provide an excellent tool for more effectively diversifying our portfolios (i.e., as one component of our clients' portfolios). Unfortunately, few of the fiduciary accounts are accredited. Are there any respectable hedge funds that will work with professional, fee-based investment managers with discretionary authority over non-accredited accounts?

Ryan Tagal: Hedge funds are most commonly structured as private limited partnerships, and thus usually can only solicit accredited investors as per SEC rules. So unfortunately, there are few if any traditional hedge funds that will accept money from an investor that is not accredited.  

If an investor is not an accredited investor but is still interested in investing with an asset manager that employs a hedge fund like strategy, there are now a bevy of hedge-like mutual funds to consider. Many of these can be found in Morningstar's Long-Short category. Many of these can provide uncorrelated return streams to traditional investments like long-only stock or bond mutual funds. Mutual fund analyst Todd Trubey covers some of these types of mutual funds. I asked him for his comments:

Todd Trubey: We believe that the Diamond Hill Long-Short Fund DIAMX is, for the investor who truly understands it, a very strong choice. It's among the most aggressive long-short funds we know if, insofar as it has a compact portfolio, takes significant positions in favored sectors, and uses its short positions offensively (to make money) rather than defensively (as a hedge on the market). We think Diamond Hill features an excellent team of investors plying a rational, sustainable strategy.

While in general we are skeptical of market-neutral mutual funds, we currently think that the Highbridge Statistical Market Neutral Fund HSKAX is best-in-breed. Their pedigree from the hedge fund world is impressive, and their sophisticated--yet straightforward--model for pair-trading makes sense. All that said, in no way should the Diamond Hill fund and Highbridge fund be seen as similar. One is quite aggressive and the other is far more conservative. Any investor thinking of purchasing one or the other actually has a lot more learning to do before making a decision.

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CharlesS: The Uniform Prudent Investor Act requires a Trustee to 1) diversify away non-systematic risk and 2) pay only those costs that are reasonable and appropriate to the trust. The Restatement of Trusts 3rd along with its commentary, which informs the Uniform Prudent Investor Act, makes clear that the default or safe harbor position for a trustee is to use passive asset class investment as the investment strategy (eliminates non-systematic risk, lower costs than active strategies, lower taxes in the case of taxable trusts and essentially never underperforms it asset class by more than the cost of investment) unless the trustee can objectively justify the greater costs, taxes and risks by a reasonably justified higher expected return. It is also clear that no particular investment is unlawful on its face but must be considered in the context of the entire portfolio.

Since most Hedge Funds are non-transparent, full of non-systematic risk, are extremely expensive, and their future returns are not statistically reliable, should not fiduciary investors stay away from Hedge Funds?

Nadia Van Dalen: Hi Charles. The bad news is that I cannot answer a legal question related to fiduciary duties and hedge fund investments, because I am not a lawyer.  The good news is that I will not charge you $350 an hour ;). But my non-legal answer is that most hedge funds don't make sense for individual investors, due to the high initial investments, tax inefficiency, and limited access to good managers, those who provide alpha. However, there are hedge funds out there that address your concerns. Some funds do provide transparency regarding their strategies, risks, and portfolios, which will help you identify if the funds have high tail risk. There are also hedge funds that have extensive operations, which reduces the non-systematic risk. Some funds even strive to be tax efficient. Of course, finding these hedge funds requires pretty extensive due diligence. No due diligence, no alpha.

If you don't feel comfortable with hedge funds, how about a mutual fund that participates in hedge fund strategies? There you are getting certain hedge fund strategies, such as convertible arbitrage, merger arbitrage, or long/short equity, and the alternative betas associated with them, for a lower price (about a 2% management fee) and initial investment. These alternative betas will help you diversify the traditional betas from your passive investments, without the transparency and operational risks that a hedge fund investment entails.

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Jerry Kerns: Hate to interrupt, but the hedge fund team has to run to a meeting, so I'm afraid we have to end this chat. Thank you for all your great questions. And thank you to our guests today. If you want to know more about hedge funds, be sure to get your free copy of the debut issue of Morningstar Advisor magazine. We have 16-page spread on hedge funds featuring in-depth articles and research by Ryan, Nadia, and Dan.

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