Are hedge-fund managers the smartest?

Offshore Funds

Published in Lipper, November 2006 Edition

A WIDELY held belief in the asset-management industry is that the hedge-fund industry attracts the brightest, smartest fund managers.

Geoff Blount, head of manager research at Investment Solutions, says this view has persisted for so long, almost no-one questions it.

He says in SA the number of hedge funds has grown from under 45 to more than 85 in the past two years, and globally the larger funds with assets greater than $1bn now manage more than $720bn.

"This growth is used to support the contention that the real brains in asset management are not sticking around in traditional long-asset management, nor are the clients.

"Are hedge managers smarter? We do not necessarily believe so. It is about the investment opportunity set afforded hedge managers versus traditional managers.

"When investing, long or traditional managers have two choices - they can choose to own or not own, a security, and only profit if it goes up or not lose when it goes down. Hedge managers have a third option - they can also choose to short the security and will then profit if it goes down."

In this scenario, traditional fund managers, who have shares they like and shares they dislike, can only benefit from the shares they like if they are right.

Hedge-fund managers, on the other hand, can buy shares they like and short ones they do not like.

Assuming both sets of managers are right, the hedge-fund manager stands to make more profit than the conventional manager.

Another element to consider is the information ratio (IR) of a portfolio, essentially the amount of return achieved per unit of risk.

High IRs are good and hedge funds typically have higher IRs than long funds as their return profile tends to be more smoothed and less volatile than long funds.

"Removing the short-selling constraint effectively doubles the opportunity set, which allows for greater diversification in the portfolio and in theory smoother returns."

Another limitation that long managers have is that they are constrained by the size of the stock in the benchmark if they believe it to be overvalued. If a stock is 1% of the benchmark index and long managers do not like it, their maximum underweight is limited to 1%.

If the stock falls, their maximum potential value-add relative to the benchmark is 1%.

No nominal value is added as capital is just protected by not owning a falling stock.

"Hedge managers can short the stock to any level they feel is prudent," Blount says.

"It is the increased opportunity set that hedge investing affords portfolio managers that creates the desirable performance attributes of hedge and perceptions of higher skill, and not necessarily smarter managers.

"Good fund managers are attracted to hedge investing as they are given greater flexibility to practice their craft and escape the more formalised and regulated environment of traditional asset management, but so are poor fund managers, perhaps more so as they see hedge funds as an easy way to make more money - hedge funds are typically more expensive, charging higher base fees and higher performance fees, normally on any positive return above zero.

"The implication is that investors need to be extra vigilant when investing in hedge funds and take extra care when assessing managers."


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