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MARKET VOLATILE: ARE THEY REALLY AN ALL-WEATHER SOLUTION?

Remember, these markets often perform poorly.

Recent press articles have sparked debate around topics such as what exactly hedge funds are, do they add value, do they really manage risk, and what are the alternatives.

It’s important to understand that hedge funds do not explicitly manage risk or deliver a certain pay-off. Their primary objective is to beat a hurdle rate, and they often do this by taking specific and concentrated risk and using leverage, delivering an uncertain pay-off, but managing volatility.

Investors should also be aware there are other ways to manage risk – buying a derivative contract that delivers an explicit pay-off over a given period with known cost and no performance fees.

Risk vs volatility

In traditional hedge funds, if a manager offsets their long and short positions against each other, the fund will have a low volatility profile. However, there is no guarantee their long positions won’t go down and their short positions won’t go up. If that happens, suddenly you have lots of excess risk.

So while on average and in normal conditions, hedge funds have less volatility than traditional long-only funds, they can have very high “potential” risk in extreme situations. It is important to appreciate that this risk is always there even though the fund might have low volatility.

Traditional long-only funds certainly have higher volatility than most long-short hedge fund portfolios and long-only funds can also underperform the market. However long-only funds cannot blow up like a hedge fund can.

It is also inappropriate to compare hedge fund performance to an equity index like the FTSE/JSE Top 40 because most equity hedge funds have less than 100% exposure by holding short positions. For this reason, hedge funds will never beat the market over time unless they use excessive leverage, which is why Warren Buffett won the famous bet that hedge funds would not beat the S&P 500 over a 10-year period.

How do you measure skill?

It is fine if investors want to pay performance-based fees to their hedge fund managers based on some hurdle rate like CPI+4%, but this benchmark should never be used to measure skill against because there are many balanced passive portfolios that also consistently deliver this return and require no skill to do so. The last thing you want is to pay a hedge fund manager a performance-based fee because the market went up 20% when a passive portfolio would have done the same thing. In South Africa, this happens all the time.

In 2001, British hedge fund expert Professor Bill Fung proposed a more practical way to evaluate the usefulness of hedge funds: by simply asking whether you can replicate or deliver a risk and return pay-off that mimics what they do without necessarily having to use hedge fund processes.

Often hedge fund managers wish for volatile markets because they believe they can add more value by picking winners and losers. Unfortunately empirical evidence shows it is far from reality.

Hedge funds generally thrive during a bull market when market volatility is low and there’s a wide return range between the winners and the losers. We have largely witnessed exactly this perfect “market weather” since the 2009 post-crisis period, and hedge funds have benefited.

However, these funds perform poorly when volatility is high or whenever correlations are high – when there is not a wide disparity between the winners and losers.

So to have substantial and continuous exposure to hedge funds is not necessarily optimal if similar pay-offs can be generated by other means. Instead of chasing past performance, investors should know under which market conditions they should allocate more or less to these vehicles.

Roland Rousseau is responsible for client risk strategy at RMB Global Markets