Last year was a difficult year for active management in general and, outside global macro and trend following strategies, hedge funds in particular. General underperformance combined with CalPERS’ decision to exit hedge funds turned hedge funds into the industry’s scapegoat. A recent New York Times article “As Hedge Fund Returns Falter, Money Continues to Flow In” summarized the angst.
Our view is that this article offers good advice but for the wrong reasons.
Yes, it is true that hedge fund investing typically requires an added layer of complication and some inconvenience to investors, especially to taxable ones. Therefore, investors better be sure they are investing in a strategy that actually hedges i.e. that provides downside protection and is truly uncorrelated with the market. The truth of the matter is that the typical diversified hedge fund of funds is public markets exposure in disguise with an added layer of fees, as the chart below depicts. This combination is indeed a bad deal for investors. In other words, beware of the hedge fund wolf in the stock market’s clothing.
Source: AQR (Hedge fund data shown is the average of the monthly returns of the overall Credit Suisse Hedge Fund Index, and the HFRI Fund Weighted Composite Index).
When implemented correctly, hedge funds play an important part in portfolios. As AQR’s Cliff Asness writes in Hedge Funds: The (Somewhat Tepid Defense, “In building an optimal portfolio, all investors should look for investments that produce long-term positive returns…that aren’t very correlated to what they already own (say, stocks)…They should want a portfolio that hedges away the risks they already bear (say, stock market risk) and includes other sources of return not very correlated with those risks. They should want that regardless of time horizon.”
Yet the broader question remains: why are people continuing to put money into active management strategies given the fees that they charge and the correlation to the broader stock market? Our friend Charley Ellis spoke a lot about active management and fees in general at Balentine’s Fifth Anniversary celebration. Indeed many public markets are becoming increasingly efficient, and it is for that reason that we tend to prefer passive management in these areas. Instead, we save active management fees for managers who, in our opinion, are truly able to provide unique exposure to strategies that are not accessible in public vehicles.
For example, Balentine has positioned Manager Skill to play a more specialist defensive role, which we believe will be more additive to fully diversified portfolios over a full market cycle. In addition, we have thoughtfully selected a manger who is able to implement in a more liquid, transparent manner. We believe these differentiators set Manager Skill apart from broader hedge fund of funds. They give us confidence that our hedge fund managers are not simply hiding in the stock market’s clothing, but instead will provide a true hedge when the time comes and, in the meantime, will offer uncorrelated returns.
It is for this very reason that our Manager Skill building block should not be expected to keep up with the returns of a strong stock market over horizons shorter than three years. It is not designed to do so. On the other hand, no one should be surprised if some of those hedge fund programs that have done so well recently turn out to be wolves in sheep’s clothing. The New York Times article is right to question why so much money still flows into the hedge fund industry and to suggest that hedge fund fees shouldn’t be excessive relative to the value they add to portfolios. But the reason is not because most have lagged the recent sharp rally in stock markets. Instead, the main point should be that if hedge funds are to command high fees, they should truly “hedge” and diversify portfolios away from stock market risk. That, we believe, would be a truly better deal for investors.