Hedge your bets on absolute returns

Jennifer Barb

Friday 26th March 2004

As the heat comes out of the New Zealand property market, investors will naturally turn to other asset classes.

International equity markets should be a logical alternative, all the more so given the New Zealand dollar's heady levels.

Returns can be good traditional equity funds offer long-term annual returns of about 8% but performance can vary dramatically from this in any given period.

The promise of good long-term returns is frequently used as a rationale for accepting losses over the short-term, which can last for several years at a time not generally attractive to the personal investor.

For most individuals, investing is about making a profit consistently. Put the money in the bank and your return is reasonably assured.

Invest in property and the returns can be far higher but so can the risks, particularly in the short-term.

Investing in global equity markets offers diversity but what sort of return and at what volatility?

Absolute return funds and hedge funds offer an attractive alternative strategy to traditional equity fund management. They differ from mainstream investment management in their goal, which is to make a profit consistently, irrespective of market conditions.

As a result, their investment policies give equal weight to maximising returns and guaranteeing capital. Carefully chosen, they can provide a low-risk method of investing in global equity markets, without compromising gains.

But don't all fund managers seek to make a profit at all times? Not really.

In recent decades, we have seen liquidity-driven bull markets in equities, in which stocks can rise indiscriminately with little or no regard to fundamental valuation tools. In such conditions it is extremely hard for fund managers to out-perform on the basis of careful stock selection.

Investors then question why they are paying fees to portfolio managers when they could simply buy an index fund.

The traditional fund management industry has responded by becoming benchmark-conscious and adopting index-hugging investment policies.

All well and good in a rising market but when the tide turns and markets fall, how many are happy to be told that we have done well "on a relative basis" because we have only lost 25% of our money when the market has fallen 30%?

Not only do hedge and absolute return funds aim to make money in all conditions, they have a better range of tools with which to do so.

Absolute return funds are able to move to a high weighting in cash as a short-term defensive position.

Hedge fund managers' ability to identify over-valued equities and sell these short, effectively doubles the range of investment opportunities that are available to them at any given time.

By varying the ratio of long to short positions in their portfolio they can have high market exposure when risk is low and low market exposure when risk is high.

The result is that these investment structures can offer good rates of return, with much lower overall risk than traditional equity portfolios.

However, hedge funds have high minimum investment thresholds, placing them outside the range of available investments for most investors on an individual basis.

While hedge fund managers have a better range of tools with which to tackle varying market conditions than traditional long-only managers, prime importance lies in how these tools are applied. Some hedge fund managers have done exceptionally well but as a whole they have given a diverse performance in recent years.

Considerable expertise is needed in identifying those that will really achieve their stated goals and in many places hedge funds can only be marketed to professional investors who can assess the risks and rewards offered.

As the hedge fund industry has boomed, there are now many on offer that are small, with little or no track record.

The risks are considerable. Clearly they will be lower in more established funds, where historical performance can be tested, but only if one has access to the relevant data and tools to carry out such an analysis.

Performance needs to be tested carefully in different market conditions, to identify funds that are highly correlated to the market when it rises strongly, less correlated in neutral territory, and negatively correlated when it falls.

Analysis and understanding of the individual portfolio manager's approach to individual stock selection is as important as it would be for traditional funds.

While a professional fund management operation is able to maintain this level of contact and information from individual hedge fund managers, it is hard for the independent individual investor to do so.

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