26/11/2008 - 22:00

Time’s right for hedge funds rebound

26/11/2008 - 22:00


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TO borrow from Samuel Langhorne Clemens - better known by his pen name, Mark Twain - rumours of the death of hedge funds are wildly exaggerated.

Time’s right for hedge funds rebound

TO borrow from Samuel Langhorne Clemens - better known by his pen name, Mark Twain - rumours of the death of hedge funds are wildly exaggerated.

In fact, hedge funds - particularly the good ones - are about to flourish as they pick through the wreckage of sound companies that have had their asset value destroyed amid the indiscriminate fear and panic cutting through global markets.

There is a long track record of many hedge funds not only outperforming traditional investment classes, but doing so with substantially less risk. Equally importantly for investors is evidence that hedge funds are at their strongest in bear markets and their aftermath.

Crestmont Research measured the performance of US hedge funds against the stock market from 1990 to 2006. The HFR Weighted Composite Index generated an annual 14 per cent return compared to the S & P 500 Index's 10.9 per cent.

The funds achieved that superior return with much less risk - 6.7 per cent standard deviation against 14 per cent for stocks.

In Australia, the Reserve Bank analysed data between 2000 and 2005 to conclude that hedge funds and equities both returned 12 per cent annually over that time - but, again, hedge funds did that with half the risk by using long and short positions to widen their opportunity set and reduce market risk.

Even in today's turbulent times, the HFR Weighted Composite Index is down a comparatively modest 10.1 per cent for the year; and more than half of that decline came in September when the financial world appeared to be going to hell in a handcart.

Considering the times we are passing through, who would not be happy with that performance?

So why all the bad press for hedge funds? They are branded as secretive, short sellers that manipulate the markets, causing company collapses and destroying investor wealth.

Granted, some hedge funds are opaque, but blaming them for market dysfunction is way off the mark. As always, something more fundamental, such as falling housing prices, is to blame.

It is interesting to note Plato Investment Management's evaluation of ASIC's short selling ban on the Australian stock market. In the month after the ban was introduced (September 22), the market dropped 16 per cent, but volatility increased substantially.

Plato concluded: "Whilst a ban on short selling may have reduced the volatility of selected stocks, the objective of regulations should be to ensure the stability of the entire market, not individual stocks."

As the ban continues in Australia and regulation tightens internationally, restricting some hedge fund strategies, we will no doubt see the demise of smaller funds and perhaps others operated internally by bigger asset managers.

As a general observation, some hedge funds have over-promised and under-delivered, but that can also be said of the investment market per se. To visit that sin on the reputation and credibility of the entire industry fails to acknowledge strategies and hedge funds with a successful history.

It is the good hedge fund operators (those with pedigree, as I call them) which will flourish as we go forward - particularly the activists who, by way of example, have generated even higher returns than standard diversified hedge funds over their short history.

Activists do not need a controlling stake in an inefficient company to shake it up and shake out superior returns for all stockholders. Unlike private equity where a control premium is paid, activist hedge funds can strategically deploy capital and still influence company performance.

Carl Icahn has proven that.

Fortune magazine last year analysed Mr Icahn's strategic stakes and activism in 16 companies - including Time Warner, Skandia, Kerr McGee and Motorola - to discover that his involvement had increased their market capitalisation by almost $55 billion ($A78 billion) in less than three years.

Mr Icahn maintains a scathing assessment of corporate America. Commenting on the government bailout of financial institutions, he targets the management and directors who have plunged global markets into turmoil.

"The primary factor that got us into this mess is the egregious mismanagement and short sightedness of boards and CEOs of these institutions, who took inordinate and leveraged risks with stockholders money, not simply external factors like the housing market slump," he says on www.icahnreport.com.

"Business cycles happen. Obviously, responsible managements should have planned for this possibility and not blindly invested in subprime mortgages and other toxic instruments.

"Unfortunately this has been a disaster for shareholders, many of which are pension funds for working people. These shareholders are paying for the mistakes, while managements are leaving with huge bonuses, such as the $2.5 billion package for Lehman executives after the bank collapsed."

In a phone hook-up, another activist manager in my own company's portfolio of hedge funds, Phil Falcone, recently told investment managers in Perth to focus on the underlying fundamentals of companies and to be patient in their investment horizons.

"Some companies will stay down because they deserve to stay down - others will not," he said.

"We are seeing some real good companies at levels I have not seen in a long time. There will continue to be tremendous volatility on rumour and bad news, [but] things are starting to settle down and we are starting to dip our toe back in the water.

"My own fund is down mid-single digits for the year, but I hope the next few months will put us back in the black."

Mr Falcone delivers 'alpha', the essential ingredient of successful investing - the mercurial skill to add value to a portfolio's returns.

Hedge funds are the legal structure of choice utilised by skill-based investors who proactively generate returns unrelated to the markets and interest rate movements - as opposed to the risk-based, passive investing in markets.

Mr Falcone, for example, has 20 per cent of one of the world's great newspaper brands, The New York Times, and is working with management to capitalise the unrealised value of its internet potential.

Fear of hedge funds needs to be balanced by better understanding of their role in the international financial system.

Sebastian Mallaby, director of the Maurice R Greenberg Centre for Geoeconomic Studies and someone with extensive knowledge on the subject, says, "hedge funds do not increase risk; they manage it - and policymakers, rather than clamping down, should make sure hedge funds have the tools to perform this function well."

At best estimate, hedge funds currently have more than $1.5 trillion under management around the globe. The good ones are here to stay, and they are becoming more transparent in the way they operate. Sophisticated investors want to know how their money is being deployed, and rightly so.

- Jon Horton is founder, director and managing partner of NWQ Capital Management Pty Ltd, a fund of hedge funds operator based in Perth. He has 20 years of experience in asset management in Australia and the US.


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