We saw in 2008 steep declines in stocks accompanied by steep declines in the returns of many hedge funds. This has led investors to ask themselves, “Do I really need a hedge fund?”
“Do I really need a hedge fund?”
Not necessarily. There are some very happy investors living in the world without hedge funds.
Investors chose hedge funds for their ability to generate returns which “non-correlated”; or in other words, returns that rise when the market falls, thereby shielding the portfolio from downside risk during bad times. Although this can be achieved through wise security selection and proper asset allocation, a well chosen and vetted hedge fund is another way to reach this goal.
“My friends invest in Hedge Fund ABC and they love it.”
It is useful to keep in mind that because asset allocation is so specific to each investor, the decisions made for other individuals should be taken lightly when discussed outside of the context of formal portfolio management. The investor and her advisor are the only individuals outside of the IRS and legal authorities who have the right to know the truth about anyone’s portfolio.
Also, research has shown that lookback bias tends to the upside. In other words, during informal discussions, individuals may exaggerate the outsized performance that they have achieved because it is always more pleasant to discuss investment successes rather than failures.
“But hedge funds failed in 2008!”
There exists an ongoing debate regarding the nature of “alpha.” Some funds and commentators argue that if the S&P 500 Index was down 37% in 2008, and a hedge fund down only 22%, the fund outperformed its benchmark, thereby generating alpha. Being down 22% is mediocre performance – and we see the chaotic environment of 2008 as an outstanding opportunity to identify true “hedge” funds and true alpha. Merely beating the benchmark does not mean that a fund generates alpha.
Hedge funds are very dynamic. It’s better to have a good advisor than a good hedge fund, because funds themselves are always changing. Past performance is never guaranteed to repeat. Buy/sell decisions are highly dependent on the skill, prudence, and discretion of the investment advisor. Good investors are committed to investing in hedge funds that have proven the ability to perform in down markets and 2008 performance can be a very useful tool in their toolbox.
“I’d only invest in Paulson – that’s the only good fund out there.”
The most prudent way to manage portfolios is through a comprehensive and rigorous process which is consistently maintained over a long period of time. The key to finding sustainable alpha is not one fund, one product, or one year of good returns.
“If I really want to hit the ball out of the park I’ll invest in a CTA Fund!”
For more volatile types of funds such as CTA’s and Managed Futures, we think it is more logical to select a few high quality funds which are well understood. For highly volatile instruments, directly investing 5% or more of the portfolio in one fund is a high concentration of risk.
For other types of hedge funds, a portfolio of fewer funds, rigorously selected and monitored, and invested in directly is an excellent investment and value proposition. We envision this simplified structure as a smaller basket of hedge funds chosen through more rigorous analysis and monitored more rigorously. We also believe that investors should avoid funds of funds whose philosophy of diversification is investing in more funds than necessary that they neither fully understand nor rigorously select.
In conclusion, we revisit our fundamental approach to portfolio management in considering our final question, “are hedge funds right for everyone?”
Although the practice of portfolio management is very technical, it is also a highly personal endeavour. Although investing in hedge funds is one way to optimise a portfolio, it is by no means the only way. A diversity of asset allocations should be discussed before deploying capital.
Hedge funds are neither necessary nor suitable for everyone. However, for the accredited investors who do possess the willingness and ability to take this risk, hedge funds offer the potential to maximise the total return per unit of risk taken by the portfolio, thereby improving the overall portfolio efficiency over time.
Prior to investing even a dollar of money, a proper Investment Policy Statement should be formed for each investor, in which the advisor conducts a thorough analysis of the investor’s return and risk tolerance, as well as constraints such as timing, tax, legal, liquidity, and unique circumstances. This is an inexorable rule that should always be upheld, regardless of the magnitude of the investor’s net worth or how much faith and trust the investor feels towards the advisor.
The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak. This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein. An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk. An investor in hedge funds could lose all or a substantial amount of his or her investment.
Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.
This document is neither advice nor a recommendation to enter into any transaction with Diamond Oak or any hedge fund or other investment. This presentation and its contents are proprietary information of Diamond Oak and may not be reproduced or otherwise disseminated in whole or in part without Diamond Oak’s consent.
Other expenses are not included in this analysis. Other expenses may include, but are not limited to: legal, accounting, trustee, administrative, marketing and sales, and custodial.