Active management can result in higher risk-adjusted returns.

Over the past few decades the financial advisory profession has been employing Modern Portfolio Theory (MPT) to devise investment portfolios for clients. Under MPT, the task of asset allocation among a variety of stock, bond and cash strategies can and should be made with an eye toward achieving higher "risk-adjusted returns" for clients with less correlation with the broad equity and debt markets. Through diversification and the timely rebalancing of investments, MPT holds, portfolios have less volatility, less sensitivity to market forces and ultimately better performance results.

The almost universal adherence to MPT among the investment advisor community reflects the soundness of its bedrock principles: noncorrelation, reduced volatility/risk and superior performance, particularly in down markets. The application of the MPT, however, may have room for improvement.

The premise of this article is that for certain investors, hedge funds offer a significant complement to MPT and should be implemented when devising investment portfolios. First and foremost, hedge funds have consistently provided noncorrelated returns, even in an increasingly correlated global marketplace. Contrary to popular perception, hedge funds have also been shown to reduce the volatility of portfolio returns. Armed with a full array of portfolio management, hedge fund managers have greater flexibility to adjust to, and take advantage of, turbulent market conditions. Finally, hedge funds generally have been shown to provide enhanced returns over time, primarily by outperforming equity markets during down periods.

Achieving Non-Correlation

It is generally accepted under MPT that diversification across a variety of equity, debt and cash strategies results in noncorrelative returns to the broader equity and debt markets. Although diversification enhances noncorrelative returns, market trends have increasingly made the task more difficult. Consider the chart below, which reflects that the correlation among various asset classes (emerging markets, small-cap stocks, international stocks, etc.) has increased over time.

Investment advisors thus must consider how to guard against unintended concentration and achieve noncorrelation in the future. One way to significantly reduce correlation is to add hedge fund exposure to portfolios. Many hedge fund strategies show histories of weak, negative or noncorrelated characteristics when compared to traditional, long-only investments. For example, in contrast to the high correlations to the S&P 500 of the various traditional, long-only asset classes reflected above, the HFR Composite Index and the HFR Fund of Funds index have relatively low correlations to the S&P 500 of 0.686 and 0.486 respectively (from 1992 to 2003).

Risk-Adjusted Returns

Maximizing a client's risk-adjusted return is perhaps the hallmark of MPT. Traditional asset allocation strategies rely on diversification among various asset classes and the timely rebalancing of investments.

The inclusion of hedge funds in a portfolio is not only consistent with MPT, but may advance its objectives more efficiently. Portfolios with hedge funds generally have less volatility, less sensitivity to market forces and typically better performance results. Indeed, it is not uncommon to see hedge funds that maintain Sharpe Ratios exceeding those of most mutual fund and separate account managers.

Higher Risk-Adjusted Returns

The chart on this page summarizes the enhanced performance history of hedge funds when measured against traditional asset classes. Although hedge fund indexes are less than perfect, hedge fund performance in the aggregate can be tracked by using the broadest hedge fund index offered by Hedge Fund Research, the HFRI Composite index.

Stating that hedge funds in the aggregate have generally performed better than traditional asset classes, however, only conveys part of the story. The characteristics of hedge fund performance tell the rest: it is typically more consistent, less volatile, less sensitive to the broader equity and debt markets, and is better in down periods in the market.

Performance Consistency

Trying to beat a benchmark (relative performance) is not the principle goal of a hedge fund manager. Most hedge funds seek to make money on an "absolute" basis, meaning despite market direction. In many cases, a well-managed hedge fund has the ability not only to outperform traditional money managers in down markets, but also to create positive returns in times of market duress. Hedge fund strategies use sophisticated fundamental and statistical methods to provide consistent and competitive absolute returns.

It is the use of these strategies that is the fulcrum for understanding the majority of hedge fund successes. The principle underlying hedge fund management is that there are inefficiencies in the capital markets at all times. These pricing inefficiencies are caused by a myriad of catalysts. For example, risk arbitrage is a commonly employed strategy that seeks to capitalize on the price fluctuations in stocks and bonds caused by corporate events such as mergers, acquisitions, spin-offs and recapitalizations. In a classic example of a merger (risk) arbitrage trade, the hedge fund manager takes a long position in the stock of the target company, and simultaneously takes a short position in the stock of the purchasing company (merger arbitrage hedge fund managers generally only take these positions after the announcement of these events, rather than speculating on corporate M&A activity). This trade is employed (typically on a leveraged basis) in an attempt to realize the price differential between the prices paid for the securities of the company involved in the acquisition and the anticipated value to be received for the securities upon consummation of the proposed transaction.

The hedge fund manager in this example is taking offsetting long and short positions, thereby decreasing the amount of systemic risk to which he exposes his or her fund. Furthermore, when assets are managed this way, the risk is placed on the completion of the transaction and not the direction of the market. Successful hedge fund tactics create a risk trade-off. While investing in traditional long-only investments, the risk taken on by the investor is full market, or systemic risk. Hedge fund investing, on the other hand, trades away market risk and assumes the risk of being able to successfully execute his or her strategy.

Active Management Tools

Due to their legal structure, hedge fund managers can outperform traditional managers because they have more active management tools at their disposal. Even those who do not pursue risk arbitrage strategies like the one discussed above have the ability to short stocks, utilize leverage and go to cash in times of market turbulence. Traditional managers have greater constraints as a result of mutual fund industry rules imposed by Congress and the Securities and Exchange Commission (SEC).

For smaller public investors, such rules serve the very important public goal of reducing the "buyer beware" concerns inherent in investing. By limiting the scope of managerial discretion and requiring positional transparency (albeit time delayed), the public has a better sense of exactly what product it is buying. For professional investment advisors with sophisticated, wealthy and experienced investor-clients, however, the legal structure of traditional funds must be recognized for the trade-off they represent. A traditional manager has fewer active management tools available and thus less ability to exploit market inefficiencies.

Downside Protection

Due to the flexibility of hedge funds to take short positions or to go to cash during times of market turbulence, many hedge funds outperform traditional investments when the market turns negative. This fact has a lasting benefit as it often takes equity and debt markets months, if not years, to recover from market collapses. The chart on the next page reflects this phenomenon.

Fund Of Funds Benefits

Once convinced of the merits of hedge fund investing, the question is how to proceed responsibly. For those investment advisors either new to hedge fund investing or with smaller increments of capital to invest, a fund of hedge funds may be appropriate. Although funds of funds have an additional layer of fees, they also offer due diligence expertise, access to exclusive and/or closed managers and lower investment minimums.

There are a number of factors that should be considered when selecting a fund of funds. A couple of obvious requirements are a competitive track record as measured against other funds of funds and the manager's ability to demonstrate a repeatable, formal due diligence process in selecting and monitoring subfunds. An effective due diligence process should include quantitative and qualitative screens to scan the universe of hedge funds, as well as the ability to stress test a proposed allocation of funds to various market conditions. This back testing will help to predict the performance of a fund of funds during periods of duress, such as September 11, 2001, or the Russian bond crisis of August 1998.

Delving a bit deeper into a fund of funds manager's due diligence process, one may also want to consider the ability of the manager to identify smaller, often newer entrants to the hedge fund space. It is commonly accepted that performance on the fund of funds level deteriorates as its underlying funds get too large. Studies strongly suggest that larger funds of funds underperform smaller ones. Brian C. Ziv of Guidance Capital suggests that funds of funds between $100 million and $500 million perform approximately +2% better annually than funds larger than $1billion. To quote him directly, "As a rule, large size [of hedge funds] is an enemy of performance. But size is a more severe problem for hedge funds and funds-of-funds than it is for traditional managers (Selecting Funds of Funds Guidance Capital, 2002)."

Another recently popular choice among advisors is the SEC registered fund of funds. These funds offer some significant benefits when compared to unregistered funds of funds, such as periodic disclosing of positions and significantly lower investment minimums. However, when comparing registered funds of funds with unregistered funds of funds, some other considerations are in order. First, registered funds of funds do not offer the same level of flexibility as their unregistered counterparts-registered funds need to invest with larger hedge funds. This creates a lost opportunity to invest with undiscovered managers, which often provide the best returns. Second, registered funds of funds must invest only with those hedge fund managers willing to give full transparency, which by definition reduces the universe of hedge funds to which it can allocate money. Third, many of the regulatory oversight benefits offered by a registered fund of funds can be achieved by investing in an unregistered fund managed by an SEC registered (and well capitalized) investment advisory firm. Finally, the majority of registered funds of funds do not charge a performance fee, but rather a comparatively larger annual management fee. This fee structure removes a basic principle of hedge fund investing: that managers should take a performance fee in order to align investors' interests with their own.

Survivorship Bias

While the benefits of hedge fund investing are significant, the concept of survivorship bias should be considered when accounting for the overall performance of the hedge fund universe. Survivorship bias is the exclusion of investment managers that no longer exist in data samples such as indexes. On many occasions, hedge fund managers simply cease operations because of poor performance or because net outflows of assets erode economies of scale. Some estimates claim as many as 25% of all new hedge funds fold after one or two bad years. Their exclusion skews the performance of various hedge fund indexes. Because of this bias, it may be difficult to accurately assess the overall performance of the universe of hedge fund managers. It is estimated by some that survivorship bias accounts for 3% of performance per year, but even when accounting for this bias, studies show that the average hedge fund outperformed the average mutual fund, but with less risk (Alexander Ineichen, Absolute Returns: The Risk and Opportunity in Hedge Fund Investing, John Wiley & Sons, 2003).

In addition to survivorship bias, other difficulties exist in tracking the performance of hedge funds on the whole. Hedge fund managers are not required to report their performance. Managers may choose "opportunistically" when to report performance-a bias that is driven at times by lack of performance. Conversely, hedge fund managers may choose to stop reporting performance because their funds have closed, and they are no longer looking to attract new assets. This self-selection bias can further affect the net performance of hedge fund indexes.

Yet another bias affecting the validity of hedge fund performance is the index flaw known as "instant history" bias. Many hedge funds are incubated before assets are accepted from outside sources. In some occasions, the incubator of the hedge fund will decide not to open the fund to outside investors due to poor performance or lack of interest. This leaves the remaining funds that come out of incubation with an instant history bias. Simply put, in these cases only the performance of successful funds is reported, thereby creating a bias towards funds with decent performance.

In assessing whether to invest in a specific hedge fund, it is important to understand that these biases impact only hedge fund indexes. Indexes should be used only as a general guideline to gauge hedge fund performance, unless investors are investing directly into a hedge fund index. Similar to analysis of traditional managers, a thorough due diligence process should help identify those managers worthy of a recommendation to clients. Hedge fund indexes, although flawed, are used in this paper for lack of a better source for illustrating how hedge funds perform and benefit a diversified portfolio. However, when actually analyzing individual hedge funds, performance should be assessed on a case-by-case basis.

Conclusion

For certain investors, hedge funds offer a compelling complement to MPT and should be implemented when devising investment portfolios. Hedge funds have consistently provided noncorrelated returns, may significantly reduce portfolio volatility and may provide significantly better returns over time, primarily by outperforming equity markets during down periods.

Gene Swanzey is vice president of FBR Investment Management Inc., an SEC registered investment advisor subsidiary of Friedman, Billings, Ramsey Group Inc. (NYSE: FBR), a publicly traded financial services company. Swanzey can be reached at (703) 469-1293 or [email protected].