Hedge fund definition?

Hedge fund definition? What are hedge funds">hedge funds? Future risk-adjusted returns will show what is and what is NOT a hedge fund. With hard work and experience we can determine those in ADVANCE. Only a small proportion of the "hedge fund" universe actually are hedge funds">hedge funds. Absolute alpha NOT repackaged beta is the value proposition. True portfolio diversification is the only reason to choose a hedge fund.

1. A real hedge fund is designed to make money in ALL conditions. The function is not to beat an index in a bull market and preserve capital in a bear. A true hedge fund manager should relish a bear market regardless of their strategy. It comes down to generating consistent absolute returns at the lowest possible risk and INDEPENDENTLY of stock, bond, commodity and currency market conditions.

2. A real hedge fund manager does not make excuses. Any talk of "the economy is in recession", "other funds are crowding the strategy", "volatility was too low/too high", "there were no trends", "market conditions did not suit our methodology", "it was a bear market", or "a once in 100,000 year storm caused losses" are unacceptable. Make money or get out of the way. Give it back to investors so they can allocate to better managers. Anyone with skill evolves and adapts their strategy or finds new ones.

3. Hedge funds are NOT an asset class; they are strategy classes. They are a method of managing money that offers a LOWER risk alternative to the traditional buying and holding of assets. They may short sell or buy within and between different asset classes and associated derivatives. Diversification is the only way to spread asset risk; with strategies the depth of risk management tools is considerably more powerful.

4. A hedge fund manager is a risk manager. A hedge fund hedges; if it doesn't hedge then it is NOT a hedge fund. A hedge fund hedges either WITHIN its own strategy OR the strategy itself acts as a hedge, reducing the risk and volatility of a traditional portfolio. Long/short and arbitrage funds hedge. Short biased and managed futures do not hedge their own positions but their negative correlation to asset classes means they perform as a hedge. Even some long-biased funds such as activist investing or distressed debt can act as a portfolio hedge. However a long-only stockpicker is unlikely to offer any "hedge".

5. A real hedge fund is NOT an asset gatherer. A list of the world's BEST hedge funds">hedge funds is a very different list to the world's BIGGEST. Assets under management is the WORST criterion to assess a hedge fund. The management fee should not be a profit centre. Hedge funds charge higher fees due to the quality of staff, support infrastructure and technology necessary to identify opportunities and manage risk in today's markets. The performance fee is the ONLY profit centre in a real hedge fund.

6. A hedge fund invests the money of the principals of the firm and outside investors are then offered the chance to invest alongside. At least 50% of the liquid net worth of the principals, senior traders and salespeople should be invested in the fund. Many traditional long only firms have launched what they claim are hedge funds">hedge funds but if the senior management of the corporate parent are not heavily invested in that particular product, it is NOT a hedge fund.

7. A true hedge fund manager is NOT in competition with other hedge funds">hedge funds. She does not care how the index does or even how other managers are doing. Peer comparison is irrelevant. If she makes double-digit returns each and every year with downside deviation and worst drawdown a much lower, preferably single-digit number, then it is a hedge fund. How any other asset, product or manager performs does not matter.

8. A real hedge fund firm basically runs one fund. It may be multistrategy and it may have mirror or feeder structures and currency classes or varied leverage options, but it is basically a single fund. A sad development in recent years, copied from the mutual fund industry, is to have what purports to be a hedge fund "range"; the idea being that if you set up numerous funds it is certain that at least one will do well and you will have a track record to market. A true hedge fund firm lives (or dies) on its core product and focused expertise. And in which fund senior management keep their own money. I want alignment not a range.

9. A hedge fund is not mandate constrained. If you look at the best track records in history, the only common characteristic is the lack of arbitrary constraints on security selection. The manager needs to stay within their competence but basically they invest in any attractive opportunity they identify. One reason returns have reduced in recent years can be traced to constraints imposed by intermediary allocators afflicted with style drift paranoia. Investors pay hedge fund fees for skill, intellect and experience. Do the due diligence, but the manager should be left alone to get on with making money in the best and safest way they see fit.

10. Hedge funds are NOT just for the wealthy. Many institutions are now turning to hedge funds">hedge funds. Good hedge funds">hedge funds are a safer and superior investment vehicle. Several countries permit retail hedge funds">hedge funds to compete with traditional funds. It is only a few regulatory holdouts in certain legacy countries that due to mutual fund lobbying and vested interests "protect" retail investors from clearly superior financial products where manager and investor interests are better aligned.

by Veryan Allen. Copyright

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Hedge fund shakeout?

Hedge fund shakeout? Some management consultants seem to have the same strategic insight into hedge funds">hedge funds as they did with Enron, mobile phones or "advising" Ebay with respect to Google's business prospects. Their recent assessment of the asset management industry in 2010 will prove as useful as the hubris they hawked around investment banks the past decade. Management consultancy clients need to insist on performance fees; if the "advice" doesn't work, don't pay. Maybe Ebay, AT&T and Enron stockholders should ask for their money back.

Does size matter? Larger firms will do better than small firms? Gathering assets maybe but not performance. EVERY big hedge fund started out as a small fund. It is well established that nimbler, newer hedge funds">hedge funds perform better. Boutique specialism is more sought after than generic warehouses. Management consultants advise large financial institutions to build up their high net worth/private banking businesses yet I have never met a wealthy individual satisfied with the "service" they receive from financial supermarkets. Rich people shop at quality boutiques and eat at the best restaurants and it is investment boutiques that best serve their requirements.

That the largest asset managers have doubled AUM in 5 years is NOT evidence of the big firms winning. If you give anyone competent $500 billion with NO further asset raising, several years from now they will have $1 trillion AUM purely through internally generated investment returns. Surely more interesting are boutique funds that had $1 million of personal, friends and family money a few years ago and now manage $500 million. That is the real story and that is where the sweet spot of the hedge fund industry lies assuming you desire FUTURE alpha and performance.

Fee compression is constantly "about" to hit the hedge fund industry yet people have been saying that for the last 15 years during which time, fees have gone from a typical 1/20 to 2/20 and up. Fees will remain the same or HIGHER for hedge funds">hedge funds that deliver what they promise to investors. Those that fail to deliver will be gone and reducing fees is not going to save them. Alpha and skill are rare; good hedge fund fees are already low given the value of the product.

As for the hedge fund shake out by 2010, thousands of hedge funds">hedge funds WILL indeed cease to exist. Many will disappear because the hedge fund manager has made enough to retire and has better things to do with their lives. Others will shut down because they did not make the grade. However, several thousand NEW hedge funds">hedge funds will have been started, more than replacing all those dead funds. It will not be a SHAKE OUT but a SHAKE UP.

by Veryan Allen. Copyright

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Hedge fund risk?

Hedge fund risk? While some opine on hedge funds">hedge funds speculating us all into financial meltdown, a rearguard action has recently emerged accusing funds of not taking enough risk. As with most endeavors, if you are being criticized by both sides, whatever you are doing is probably correct. Most hedge funds">hedge funds are less risky than traditional equity funds and if a manager does not see opportunities for the strategy he should not invest for its own sake.

Most hedge funds">hedge funds target returns investors need - a RELIABLE performance somewhere above 10% per annum, EACH and EVERY year. They are prepared to give up some potential upside to reduce downside risk. The absolute return, hedging and risk management skills are what matter, not outperforming some arbitary stock index.

Another critique is that hedge funds">hedge funds often hold significant cash; the decision to hold cash is important yet some less enlightened investors think funds should fully invest, complaining of paying hedge fund fees for simple cash management. Occasionally, I go fully 100% to cash when I consider rewards are unlikely to compensate for the possible risks. Why? Because that's the job.

Take a typical hedge fund aiming for 15% a year at 10% volatility and no drawdowns worse than 5%. If a fund of funds, or any investor for that matter, wants higher returns, just borrow and lever up the performance to almost any level, within reason. Use 2x leverage and, assuming you can borrow at 5%, to get fund returns of 25% at 20% volatility and 10% drawdowns. Why ask the underlying fund to increase risk?

by Veryan Allen. Copyright

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Liability driven investing?

Liability Driven Investing or LDI is getting lots of attention. Overdue considering the ONLY reason pension plans exist is to pay beneficiaries with absolute returns. But are the absolute liabilities being calculated correctly for the future growth in longevity? The correct way to categorize human age is now: 0-17 minor, 18-79 young person, 80-109 middle-age, 110+ senior citizen.

Invest in lower risk alpha. Your great-great-great grandchildren will thank you...in person. Pension funds were established when people worked to the bone for 40 years at the same company and when they retired, for the 5 years or so they typically had left, the employer would take care of them with a retirement pension. This is outdated with people likely to have many jobs, several careers and live decades past three score and ten. Not so long ago making it to 70 was comparatively rare; nowadays it seems a young age to depart the mortal coil. Here in Japan there are 60 year olds retiring this year who WILL spend half their life as retirees. Not surprisingly Japanese pension funds are piling into hedge funds">hedge funds - the most reliable source of return when bonds yield so little.

I recently visited Yuzurihara, a village near Tokyo, which has a higher percentage of active/healthy 90+ year olds than ANYWHERE else on the planet. Of course Japan is famous for longevity and offers a window into the future for other countries. I have been buying stocks of Japanese companies that market to older age groups yet there are still very few in USA or Europe. The demographic trend is ignored by marketers and pension fund actuaries at their peril. Add a decade or two to those longevity tables and recalculate the asset/liability model. Not pretty.

Pension actuaries are going to be very wrong in their "expectations" for people expiring "on time". Life expectancy can't be looked up in statistical tables like logarithms. Those numbers are invariant, age is not and thus liabilities are not. Pension funds calculate liabilities, in part, by GUESSING how long beneficiaries are going to live. That estimate is made using PAST longevity data. Fast changing lifestyle and work practices combined with vastly increased knowledge of health and the aging process mean historical longevity tables are probably of limited use for estimating FUTURE longevity. Pension liabilities are worse than they appear due to the rapid leap in life expectancy.

Nowadays 70 year olds run marathons, climb Mount Everest and spend their spare time updating their Facebook profiles. Kirk Kerkorian at 88 is trying to sort out General Motors GM, Alan Greenspan at 80 is setting up his new consultancy. In some respects, Hugh Hefner, also now 80, puts it best, "80 is the new 40". He's right. And, of course, some of the better hedge funds">hedge funds are managed by young people, that is anyone under 80 years old.

Anti-ageist laws still have not caught up with sex and race discrimination laws. There is a lot of age discrimination in employment practices. This reflects outmoded compensation structures and age prejudice. Television advertising ratings emphasize 18-49 old viewers, based on the bizaare notion that after 49 you won't change your buying habits; but the over 49 year olds I know spend money like a teenager and they have a LOT more of it. Yet marketers seem to have little interest in them. Societies evolve just like financial markets.

by Veryan Allen. Copyright

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How much alpha is there?

Alpha? Some say there is a reducing supply of alpha. A few even attempt to put a number to the amount. They remind me of the patent examiner a century ago who said he didn't see any future for his profession as "everything" had already been invented. There is plenty of alpha available and far, far more to be generated in the future.

Total alpha sums to zero so that puts the emphasis on extracting it from OTHER market participants, ie having skill. Given tens of trillions of dumb dollars in the global markets there is vast opportunity for capturing and redistributing that alpha to the few that know what they are doing. Alpha can only diminish if the markets became efficient but the fact is markets are MORE inefficient than ever before.

There are many investment strategies that have already been invented. These range in performance and value from newspapers ACTIVELY picking stocks, commonly known as "passive" index tracking eg Dow Jones, FTSE or Nikkei, to the strategies developed by Renaissance Technologies for the Medallion Fund. In between there are many of varying levels of worth and sophistication of which some are used in long only funds and many more in hedge funds">hedge funds. But there are numerous new methods of making money waiting to be discovered and those will be NEW sources of alpha.

New strategies have emerged as a consequence of growth in the variety of underlying products that can be traded and the relationships between them. Complexity and innovation in assets, hybrids and their derivatives offers investment and arbitrage opportunities and I see no reason why financial product innovation should cease any more than other technological field.

Whether it was NDFs, CFDs, variance swaps, ETFs, credit derivatives, commodity linked bonds, CDOs, SIV-lites, CPDOs, PIK toggles, carbon credits, freight, property derivatives or weather and catastrophe reinsurance, all these created opportunities for new investment strategies or NEW alpha. The FEW skilled will make money from these inventions while the MANY unskilled will lose money on them. Portable alpha? The redistribution of investment returns from the many fools to the few geniuses.

Then there is geography. New places become investible every year making more alpha available. I am in China this week and the range of things you can do as an investor here is increasing rapidly. Despite being here I just bought some cocoa options today because of information I received today from contacts in Sao Tome and Principe and Cote D'Ivoire. The global village we now live in and the technological interconnectedness is a GROWING source of alpha.

Whether by asset, strategy or geography, ALPHA IS NOT IN SHORT SUPPLY. When a new hedge fund sets up I regard it as neither a threat nor a competitor to other funds. They are not going to affect alpha generation as their strategy should be unique. They are in a peer "group" of one or should be. If a strategy gets crowded then do the opposite!

Of course some strategies are now mature and in the public domain and THAT alpha is limited. As with any product a hedge fund manager must always be developing new strategies and enhancements to their existing strategies and protecting their intellectual property as long as possible. A copied strategy is a dinosaur strategy unless your edge lies in implementing the strategy better than others.

One thing is certain. We are NOT running out of alpha and there will be plenty around in the future. I don't reveal future product ideas but no-one is managing a Mars "global" macro fund...yet.

by Veryan Allen. Copyright

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Pension funds need hedge funds

Many pension plans do NOT invest in hedge funds">hedge funds...yet. Smaller pensions, who COULD get properly invested in good hedge funds">hedge funds quickly and easily, are the main holdouts. More worrying is that the portfolio percentage allocated to hedge funds">hedge funds remains far below necessity while vast amounts continue to be gambled on long only equity. Why do investors hope for bull markets when safer ways of managing money now exist? The real prudent man hedges.

The poor performance of long only demonstrates the downside risks of non-hedged equity as an asset class. In contrast recent market fluctuations have been ideal for many hedge funds">hedge funds, particularly those running long volatility strategies. Of course beta biased funds had a rough May which is why it is important to differentiate between the true alpha generators and the beta repackagers.

Conservative investors ought to use modern financial technology. Competent hedge funds">hedge funds lessen the agony of drawdowns, negative compounding and increased plan sponsor capital contributions. The case for hedge funds">hedge funds is proven. Over 50 years of data clearly demonstrates better performance at lower volatility and lower risk, beyond any reasonable doubt.

Standing by and watching liabilities grow while the asset side vaporizes is not prudent. What are investors waiting for? Another 10% drop in the markets? 20%? Perhaps they are hoping a mañana attitude will bail them out. Maybe it will this time but should they be making that kind of bet? The job is to match liabilities with asset growth and proper hedge funds">hedge funds are a way to help do that.

by Veryan Allen. Copyright

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Hedge fund billionaire?

Hedge fund compensation receives lots of publicity but overstates what managers earn. Most "pay" is capital gains NOT income. You can't take a firm's AUM and returns, plug in fees and get a "wage". Large funds employ many highly qualified people who deserve their share plus expensive technology to implement strategies. High "salaries" occur when substantially more in absolute returns are generated for clients.

There is nothing new about hedge fund managers "pocketing" billions. George Soros and Warren Buffett got that in their "paychecks" for some years in the 1990s. Jesse Livermore "took home" over $100 million in 1929 for running his hedge fund which is far more than a billion in today's money. The highest annual "compensation" ever received by any hedge fund manager was the original market wizard Munehisa Honma.

James Simons, founder of Renaissance Technologies, was "paid" $1.5 billion last year. As with ALL real hedge fund managers he eats his own cooking. He is the largest investor in Medallion Fund which is the world's best quantitative hedge fund. The fund performed well so he had investment gains. It was NOT salary. Yes some "income" came from fees but that reflects the demand and the hard work entailed in generating CONSISTENT absolute returns and the quality of employees. Senior management having SUBSTANTIAL personal assets in the fund is mandatory alignment with clients.

Jack Bogle, founder of Vanguard, prefers "cheap" index funds. I don't know why as they are risky and expensive considering the large losses, little "work" involved and lack of skill. If a firm "manages" $1 trillion and charges "just" 10bp, that is $1 billion PROFIT every year even when the returns are negative! Lose investors' hard-earned money? It's the market's fault not theirs, right? Get someone else to make a list of stocks for a benchmark, buy them, and then endure many years below the high water mark! Who would invest in such a risky product as an index fund?

The S&P 500 index is just an ACTIVELY managed long only strategy. A hedge fund's franchise is in trouble if it is below its high water mark for even a single year but Bogle's Folly, the S&P 500 index tracker, gets away with not making a cent since last century. Unsuitable for any prudent investor's long term financial goals. Avoid index funds as they cost too much. The fee structure of hedge funds">hedge funds is STILL misunderstood. If the net absolute returns are good the fees are fair.

Financial engineering is no different to mechanical engineering in that you get what you pay for. Performance costs need to be assessed against the quality and engineering of a product. The Trabant and Bugatti Veyron are German cars. You could buy a Trabant for $100 but you can't buy a Veyron for $1 million. So which car is CHEAPER? Which has the better performance? The Bugatti Veyron is the BARGAIN if you consider the VALUE of the product. Which would you invest in? The Trabant index fund or the Veyron hedge fund? 2 and 20 for alpha is a great deal compared to 0.10 for beta.

Good hedge funds">hedge funds are cheap and index funds are a rip-off considering what investors receive. If anything the best hedge fund managers are underpaid. The Medallion Fund returned 29.5% AFTER its 5% and 44% fees. The "highly respected" S&P 500 index fund made a derisory 4.77% this year, had a 50% drawdown again a while back, has STILL not made up for the litany of losses and yet charges an egregious 18bp - for what? Long term investors would have done better keeping their money in the bank for 8 years than gambling their savings away on speculative "passive" funds.

An index fund "manager" on minimum wage is overpaid whereas Jim Simons, relative to his value, is undercompensated. Worrying about hedge fund manager "pay" is like refusing to use Google because Sergey Brin and Larry Page "trousered" over $5 billion each last year. If you don't like that "salary" then don't Google? If you don't want 80% of the profits a talented hedge fund manager makes for you then don't invest alongside them. There are plenty of "cheap" relative return and index funds out there to lose your savings in.

Are good hedge fund managers really paid so highly considering how well their clients do? That money is NOT salary. The hedge fund industry seems to be the only business that considers people successfully investing their OWN money as paid compensation. Those pay figures are not a wage. They are simply a measure of the increase in equity in their own hedge funds">hedge funds.

by Veryan Allen. Copyright

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