A few years ago, many of us invested in hedge funds via funds of hedge funds. The better examples generally offered a better risk-return trade-off than pure equity investment, while offering likely returns ahead of bonds. However, most had some net exposure to equity markets.
Even without the discount swings that many investment trusts in the sector suffered (or the severe problems caused to some by illiquidity in their underlying assets), this feature made funds of this type less than ideal diversifying assets for an equity-based portfolio (and much less good in extreme circumstances than many of us expected).
Critically, many hedge funds claimed to deliver strong returns with modest volatility most of the time, and some delivered just that. For an investor holding hedge funds and cash, this probably means they were good investments. But to a long-term investor with most of a portfolio in equities, what should matter most is how these investments perform when equities do badly.
In short, many investors have done badly in the last five years from their hedge fund investments because the investments did not do a good job, but many others (with hindsight) just bought the wrong hedge fund investments.
The right hedge fund investments
Fortunately, there are hedge funds available in a form suitable for UK investors that did well in 2008, have liquid portfolios, have low expectations of big discount swings (or are open-ended) and have long records of showing low correlation with equity markets – despite often offering returns over many years that compare well with those expected by bond investors or hoped for by equity investors.
This group of hedge funds usually get labelled ‘macro’, ‘CTAs’ or ‘managed futures’. They typically do not hold illiquid assets or individual equity or corporate bond investments, preferring to invest in currencies and interest rates, plus indices of equities, bonds or commodities, typically via ultra-liquid futures markets.
Some leading examples use computer modelling to capture trends (up or down) in markets, while others rely on the skills of individual managers.
Some of these investments are available to retail investors via investment trusts (like those from Brevan Howard and Blue Crest). Others can be bought through a Ucits III structure (eg, Aspect or Standard Life GARS) and a few are offshore funds with UK reporting status (eg, Matrix Ascension Fund, which feeds into Winton Managed Futures Fund).
Many of these funds have long records of high returns (some over 10% a year on average) without excessive risk, plus few bad years, and little correlation with equities or bonds.
To see the real effect of these investments, consider first the actual risk & return behaviour of (say) the FT-Apcims Balanced Index. Now look at what happened over the past (say) five years if an investor allocated 90% of a portfolio to that Apcims index and 10% to Macro/CTA funds like those mentioned above.
Taking the last few years as an initial guide would suggest that adding more in funds of this type sees the volatility in the portfolio’s overall value drop, yet the average annual return rises.
These hedge funds are unlikely to match equities in years when stock markets are very strong, so one should not rely on them adding performance every year to a traditional portfolio, but investments like these really have improved the risk-return balance by offering genuine diversification when investors need it most.
Wasn’t that what we all wanted in such a holding?