If there is one thing investment managers agree on, regardless of vehicle, if is the value of diversification, which is experiencing new importance in an era of negative to flat equity returns. Butthe definition of diversification can vary significantly. Who’s who in managed money in ways depends on which definition a firm uses.
A great deal of time and energy has been spent battling the myth that alternative investments as a rule are much more risky than traditional long-only investments. This prejudice persists despite overwhelming evidence to the contrary, evidence that is starting to change the look of managed money.
It is not newsworthy – but probably necessary – to point out that alternative investments have outperformed traditional investments in recent years. Those clinging to the myth that alternative investments are riskier than traditional strategies would argue against chasing hot money and have encouraged investors to stay the course even when that course has directed them down an ugly unprofitable path for three years now.
It could be argued that these defenders of the long-only world are the ones clinging to the hot-money memories of the 1990s equities joy ride that came to a screeching halt in March 2000. They argue that equities markets – over time always go up. While true, the question is over how much time?
It was during the recent period of unprecedented appreciation in equities prices – dating to 1982 or 1974, depending on who you ask – in which modern notions of what constitutes good performance and who produces it were formed. Traditional investment managers produced steady profits, and alternatives weren’t needed to make money. With the stock market on the upswing, managers adopted the goal of outper- forming a predetermined benchmark, usually the S&P 500. That is a reasonable goal during periods of steady equity market growth. It is also a goal that has proven hard to maintain during irrational exuberance, as in the late 1990s and one that offers little solace to investors in bear markets. (See “A different ball game,” right)
In his book The Prudent Investor’s Guide to Hedge Funds, James P. Owen reports only 7% of diversified domestic equity mutual funds beat the S&P 500 in the second half of the 1990s. Owen spent his career working for traditional money management firms but became enamored with hedge funds after retirement, eventually working for one.
Hedge funds however, have always been absolute return vehicles, which is what traditional investments were, Owens claims, years before the relative return craze. Absolute return strategies attempt to produce consistent returns and preserve capital. They look for opportunities rather than investments. Hedge funds are defined by their structure rather than their strategies, which are numerous and varied.
Their reputation as high risk, mysterious vehicles stems from the global macro strategy, which is the most open-ended approach characterized by high profile managers. That strategy went from the most popular 10 years ago to approximately 10% of the asset class today. There has been a resurgence of the traditional form of hedge fund in recent years. Long/short equity strategies compose nearly half of all hedge funds and most others involve arbitrage strategies that use highly liquid instruments.
While diversification is a virtue that nearly all managers agree on – both traditional and alternative managers their definitions of it are another attribute that varies greatly. In the traditional long-only world, diversification means a mix of stocks and bonds or a mix of value and growth stocks or a mix of stocks across sectors or perhaps a mix of mid-caps and blue chips. While those mixes may sound diversified to the average investor, most alternative investment managers would say only the stock and bond scenario provides substantial diversification. The other attempts try to diversify using only one side of the market – the long side.
One good thing about diversification is it can feed off itself. Hedge funds diversify a long-only investment portfolio, which claims to be diversified across some parameter; market neutral strategies offer a further diversification; fund of funds further diversify an alternative strategy; and managed futures offer even higher non- correlated benefits. Even within managed futures, increasingly more managers are creating strategies that offer diversification from the traditional long-term trend-following approach.
A DIFFERENT BALL GAME
Tying your investment instrument to the performance of the S&P 500 made sense and led to huge growth in mutual funds numbers (estimated to be to 10,000 from 500 between 1980 and 2000). But fund managers could not keep up with that growth in the late 1990s and have been tied to an anchor since March 2000.
Whether considered a part of the hedge fund universe or a completely separate asset class, managed futures can stand on its own as a strategy offering solid risk-adjusted returns in any market condition. The most common managed futures strategy is technical trend following. The traditional world refers to such an approach as market timing – something it likes to claim does not work. The long- term results of many practitioners, though, strongly suggest otherwise. Certainly, trend following faces difficult periods and a maddening tendency to give back a high portion of open equity profits. This has led managers to try and build better mouse-traps. By developing strategies to anticipate moves rather than jump on a moving trend, the asset class has created diversification from within.
Sol Waksman, president of commodity trading advisor (CTA) tracking service Barclay Trading Group says CTAs can be distinguished by method (systematic vs. discretionary); by portfolio concentration (financial, agricultural, energies or diversified); and by their trading time frame (short, medium or long-term). The most common separation in style is trend-following vs. countertrend strategies. Methodology, portfolio concentration and time frame can play a role in diversifying return patterns, but a program’s style is more of a philosophical difference.
“What you have to ask yourself is if when a trader is buying, is he buying strength or is he buying weakness?” Waksman says. “He can be a trend follower [trading] a shorter time frame, but if the market is rallying and he is selling, then he is a true countertrend trader. The question is, are they following or are they anticipating?”
Titles can be overrated. If a manager is able to hold down losses or earn profits during periods a typical trend follower experiences drawdowns, then he is providing diversification. Waksman notes that there has been a recent upsurge in trend-anticipatory managers as well as managers using multiple time frames. It is a sign of optimism and expected growth that an asset class managed futures – once thought as a product used just to diversify an equity position has sub-strategies being developed as a diversification for other managed futures programs.
Alternative investment strategies have the benefit of offering diversification from the much larger traditional investment world. Some of its practitioners, buoyed by recent success, have floated the idea that their strategies may be more appropriate from a diversification standpoint as a stand-alone strategy than a traditional fund that only plays the long side. Key to those claims are alternative investments’ ability to profit in any equity market cycle and their goal of providing absolute return rather than just outperforming a benchmark.
Waksman argues that managed futures by nature are much more diversified vehicles than long-only strategies. “You can be the best stock picker in the world but you lost money [the last few years]. CTAs can be either long or short and are not limited to one market,” he says. “Equity markets as a whole tends to move together.”
Others point out that not only logic, but empirical results, indicate funds that play both sides of the market are more diversified than long-only strategies.
“A diversified group of hedge fund strategies or a fund of funds is going to be much less risky than a mutual fund and the numbers are there to show it,” says Hedge Fund Research (HFR) founder and CEO Joseph Nicholas. HFR has recently launched HFRX, a group of investable indexes consisting of eight of the most common hedge fund strategies and an equally weighted index representing the hedge fund universe.
While those familiar with alternative investments are preparing for further growth based on recent performance and a growing consensus that the 1990s were an anomaly, many from the traditional side are suspicious of alternatives and have been calling for – with some success – greater regulatory scrutiny of them. Many traditional investment vehicles seem convinced that short selling and the hedge funds and CTAs that employ it are even more responsible for the malaise in equities than scandals involving accounting, stock analysts, questionable executive compensation and market over- valuations. However, while the traditional industry is calling for alternative investment reform, individual members are peddling strategies that sound suspiciously similar to hedge funds themselves.
Traditional investment stalwarts such as Charles Schwab and Oppenheimer Funds have offered either hedged products or registered fund of funds in recent years. Schwab’s Hedged Equity Fund isa long/ short mutual fund using hedge fund strategies with more transparency, less risk and greater oversight according to co- manager Robin Jackson.
Oppenheimer’s 2001 purchase of alternative investment provider Tremont Advisors to develop registered hedge fund products was another sign of this trend. Oppenheimer purchased Tremont for its expertise in developing fund of funds products and to avoid possible conflicts of interest that could arise from an Oppenheimer manager running both a hedged product and a mutual fund, according to a spokesperson.
Changes in short selling rules in 1997 allowed traditional funds to adopt hedging strategies and the bear market has led more funds to take advantage of them. Lake Partners, a Greenwich, Conn., investment firm, developed a pool of hedged mutual funds that it has been offering to institutional investors since 1998. Chairman Rick Lake estimates that there are more than 200 mutual funds that use some form of hedging.
While some traditional mutual fund providers are merely sticking their toes in the water, offering products they call retail but still are restricted to certain investors, others such as Rydex have offered a series of short-selling mutual funds open to the wider retail public. Rydex’s short selling funds are available through third parties for a minimum investment of $2,500 and the Prudent Bear fund, a short-biased mutual fund offered by David Tice and Associates, has a $2,000 minimum investment.
If there is a disconnect between those calling for a more open approach to alternative investments and those calling for more restrictions, it is whether they are defining alternatives by their strategy or their structure. The strategies themselves are being duplicated in the traditional world as increasingly more mutual funds are using hedging techniques. The structure is often where hedge funds gain secretive reputations and complaints of lack of transparency and high fees. It is useful, however, to remember that hedge funds’ performance is measured net of those high fees, which can run as high as 25%.
“You would have to say that hedge funds have earned their fees in recent years and there is a question [as to whether] mutual funds have,” Nicholas says. “There is a demand for performance and people are willing to pay for performance, which makes sense.”
It is also good to remember – as the critics, including the SEC, call for more registration – that exemptions to registration and greater oversight provided to hedge funds are based on them restricting their offerings to certain categories of high net worth individuals and institutions. There is an oft-stated fear that these products will work their way into the retail market, but current regulation won’t allow unregistered funds to sell to retail. Lake points out that although many of the new products are classified as retail, they still are restricted to categories of high net worth investors. He maintains that SEC concerns have often been taken out of context and what the regulator is doing is creating a clean playing field for wider use of hedging to allow for the prudent spread of hedge fund strategies for all investors. “Each one of these new investments find its way to a wider and wider audience,” Lake says.
Because of concerns about their structure and institutional demands for transparency, the market is meeting the demand. More registered hedge funds, fund of funds and index funds are hitting the market offering the benefits of absolute returns while providing safeguards such as daily transparency.
“The availability of an index in the hedge fund space that is representative is a huge step forward, a watershed step because it creates a concrete point of reference for investors,” Nicholas says. “The SEC is not going to be concerned if you eliminate the fraud and you get full transparency and you get real prices on everything. When there is no risk of fraud and there is real clarity as to what is going on – what kind of leverage, what kind of exposure, what kind of concentration, all that stuff can be controlled – then you are eliminating concerns of the regulators,” Nicholas says.
When it comes to hedge fund strategies there appears to be a race toward the middle. Traditional hedge fund managers are increasingly offering registered products at lower minimums and traditional mutual fund providers are offering hedged vehicles to retail investors.
Safer investments should not be withheld from the retail public that suffers most from strategies that lack diversification to preserve capital in bear markets. They should have the same choices as high net worth investors as long as those choices are structurally sound, transparent and offered in the appropriate vehicle. |FM
All investment managers agree – diversification is valuable in any portfolio. Some managers claim to provide it and others tout themselves as the way to achieve it. Although, their definitions for what constitutes it may vary significantly.
Copyright Futures Magazine Group Jun 2003
