A truly alternative solution for investors

It can be hard to separate the wheat from the chaff when there is no immediately apparent difference between them. These days, the world of hedge funds more closely resembles a field of chaff, with just a few shoots of wheat here and there.

Given that there are some 10,000 hedge funds in existence around the world today, and only one in 10 is really a hedge fund in the true sense of the meaning, it takes a highly skilled and firm hand to sort through them all. In recent years, fund selectors – some quite renowned – have been offering clients some of these supposed "hedge funds" that match neither the concept nor even the definition of this asset class.

Put simply, our experience has shown that the prototype hedge fund should embody three main principles: 1) it invests in liquid products at favourable prices, 2) it neutralises the risk of an adverse market or performance at source, using hedging techniques such as short-selling, 3) it aligns the interests of clients with those of the fund managers, with the latter acting as both personal investors in their hedge fund and owners of their investment company.


A universe of false promises

Regrettably, the term hedge fund is still bandied about by quite a few players who do nothing to neutralise market risks and, what is more, sometimes use large leverage to intensify them; not to mention the impostors, the frauds or the out-and-out thieves. Certain funds masquerading as hedge funds are in reality traditional funds (long only), like the many pseudo-hedge funds concentrating on just one sector or country. Other "false" hedge funds are more like banking and actuarial operations, for instance by concentrating on credit card loans or even car leases or life insurance policies. Others still should be classified under certain specific activities, such as asset-based lending, where the assets are devoted to factoring.

Moreover, simple quantitative studies show that the risk profiles and return of such funds differ fundamentally from those of hedge funds. The impostors are often characterised by illiquid investments, a profile showing recurrent, low-volatility monthly gains in normal times, amplified by leverage, tending to produce an attractive annualised return and an exceptional reward-to-risk ratio (Sharpe ratio).

However, once the first cracks start to show in the economy, more substantial monthly losses also appear. The risk profile of this type of fund is thus frequently underestimated by some less canny investors. Although a positive Sharpe ratio is generally a good sign, an excessively high figure should always be viewed with suspicion.


The year of all risks

For the hedge funds sector as a whole, 2008 will undoubtedly go down in history as one of the worst ever in terms of management performances, given the particularly poor showing in economic and financial risks, but also the unprecedented virulence of systemic risks, regulatory risks (such as the ban on short-selling), or operational risks. Hedge fund managers found themselves having to juggle with counterparty risks, limit the risk of funding or a margin call, anticipate redemption risks or even liquidity risks. Consequently, the typical fund manager often had to devote more time to fund administration, negotiating banking relationships, or even analysing operational flows, or managing his assets.

To cap what was undoubtedly one of the darkest financial years in living memory, the scandal of the century came to light in December, when it emerged that Bernie Madoff had swindled investors out of $50 billion (Dh183bn) in his Ponzi scheme. Already tainted by poor performances and other frauds, confidence in hedge funds certainly seemed to have hit rock bottom. If there is one lesson to be drawn from such a disastrous year, it can be summed up in a maxim we have been following for a number of years already: If a hedge fund is too complex in structure to be understood, then don't buy it. For today's investors, however, hedge funds do offer some new and highly attractive prospects. In all the panic surrounding the world of hedge funds, and after being tarred with much the same brush, some of the world's most renowned managers are now reopening their investment vehicles to new subscribers – and at very favourable conditions.

Moreover, the ebbing wave of deleveraging, combined with redemption requests from private investors, acts as a contrary indicator: competition among managers is fading while the financial markets are become increasingly inefficient. Thus, a smaller group of players now have more and more opportunities for making gains.

As usual, the world of hedge funds has adapted at an impressive pace, and the results are already quite convincing. What is more, risk premiums and arbitrage spreads have rarely offered so many opportunities, whether in the markets for foreign exchange, bonds, commodities, equities, or even credit. And quite a number of managers will be there to seize them. The best hedge funds should thus continue to outperform many of the financial markets, while still offering capital protection over a market cycle. It is also worth remembering that, in the long term, their weak correlation with traditional assets make them essential tools for diversification.


New prospects in the field

In addition, a number of self-regulatory initiatives augur well for a healthier future for hedge funds. New associations governed by strict rules, standards and codes are emerging, such as the Hedge Fund Standards Board, launched at the start of 2008, or the President's Working Group on Financial Markets, behind the Best Practices for the Hedge Fund Industry. Certain requirements in terms of transparency, independent administration and a robust organisation – with segregation of operational and trading activities – thus appear to be met.

Finally, it should be remembered that carefully selected hedge funds offer investors a truly alternative solution, relieving them of the need to make decisions in terms of strategic asset allocation. Apart from the difficulty of this in a balanced traditional mandate, such decisions are actually crucial, given that the bulk of performance depends on them. Therefore, in terms of the most promising investment strategies, a rigorous selection of macro and long/short funds offer excellent prospects today.



- Bertrand Demole is the Head of Hedge Funds, Alternative Investments, at Pictet & Cie. The opinions expressed are his own

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