Dangerous Definitions: Know Your Hedge Funds
The hedge fund industry may appear to be a risky investment choice right now but not every investment instrument referred to as a 'hedge fund' may necessarily behave according to the true definition. With a little research, hedge funds can still provide a good return.
On the surface, the hedge fund industry, like telecoms, dotcoms and banks before it, is now apparently crashing and burning. Schadenfreude all round, some may say.
In recognition of the fact that 'hedge fund' is an unhelpful modern misnomer in the same way that 'government bailout' is, we might like to establish some workable definition by which to measure what a hedge fund actually does. Or, rather, should do. How about:
'Moderately leveraged, bi-directional, speculative trading in liquid and transparent markets in order to achieve absolute returns unrelated to traditional asset classes.'
This sounds simple enough, so why do most hedge funds have an in-built directional bias? (Long/short equity? Don't you believe it.) Why do they put themselves in blatantly illiquid markets and structures such as collateralised debt obligations (CDOs) and special purpose vehicles (SPVs)? And how come so many of the strategies are utterly dependent on extortionate levels of leverage to have any chance of making a return?
None of these things should be a problem for experienced, professional, institutional investors, though. After all, if there is anyone here that cannot accurately and properly evaluate the ease and cost of bi-directionality, monitor appropriate leverage, gauge general market direction and measure market liquidity/transparency in an investment strategy then they should be reading comic books and not gtnews.com. Right? So how do these so-called hedge funds rake in so much money? Is it intellectual intimidation? Is it their celebrity status? Is it a herd mentality? Perhaps it's the 'greater fool theory' at work?
Now we are hearing that there are 'issues' with investor redemptions at certain hedge funds. That market conditions do not allow for orderly position liquidation without catastrophic losses. Even worse, there may be forced liquidations because they can no longer finance their deeply underwater positions.
Well, none of these things can be true, can they? Not if they were adhering to the very sensible definition of a hedge fund that I set out above. So whatever they do (did?) and whatever they are (were?), they are not and were not hedge funds. Not by this definition. As calculated by Hedge Fund Research, Figure 1 below shows their scorecard for the year-to-date.
| HFRX Index | OCT | YTD | Std Dev (ITD Ann) | Sharpe (ITD Ann)** |
| HFRX Global Hedge Fund Index | -9.26% | -19.79% | 6.92% | -0.22 |
| HFRX Equal Weighted Strategies Index | -9.87% | -18.27% | 6.21% | -0.31 |
| HFRX Absolute Return IndexHFRX Absolute Return Index | -4.39% | -9.36% | 3.99% | -0.02 |
| HFRX Market Directional Index | -13.69% | -23.31% | 10.36% | 0.10 |
These results are not very pretty. It can now be seen that many of these so-called hedge funds were simply the financial equivalent of wolves in sheep's' clothing. As such, with 'alternative investments', it is crucial to know exactly what the instruments are that you are investing in.
On the other hand, and in the interest of total fairness, if investors had the opportunity of swapping their 'traditional asset class' losses for, say, 20% losses in hedge fund investments, there would be no of lack of takers: S&P500, FTSE100, Nikkei, (sub)-merging markets.... Need I go on?
Comparative benchmarking aside, it is reasonable to assume that that most hedge fund investors might be at least a little disappointed and perhaps even angry to discover that their fund is not behaving in the way they expected it to. Bad experiences can lead to a negative image of hedge funds developing in the minds of the investment community. But this would be a shame for those hedge funds that are strictly adhering to the definition I gave earlier.
Never mind all that though. We now have all these other alternative investment instruments clambering all over each other in a scramble for investment. Where do they go from here? What relevance is any of this to the readers of gtnews.com?
The first answer is easy. As before, they will migrate into a new investment arena and morph into being its undisputed experts. (Of course, it will have to be one of the few remaining ones that their particular skills have not yet decimated.) Rest assured, just as the number of new hedge fund launches exploded following the collapse of global equity markets in 2001-2003, they will reappear within a few years of this debacle, this time as currency managers.
They have not yet destroyed the currency markets because they were too busy running their multi-billion dollar market/equity/arbitrage/neutral/convertible/swap/debt strategies. With every day that passes, more and more of them are finding that they have fewer billions and more time on their hands.
The second answer is also easy. It is relevant to the readers of gtnews.com because when these currency managers do show up (and they will), they will appear to be just as fresh and exciting as they were before. And even more dangerous.
Article by Christopher Cruden began his business career in 1980 as a gold analyst with an investment bank in South Africa. In 1983 he joined Dean Witter, Reynolds Inc. as a securities salesman based in the U.S. and it was during this period that he became involved with the Alternative Investment Industry. In early 1988 he returned to the UK and became a director of Adam, Harding and Lueck Asset Management Ltd (AHL). After the sale of this firm to Man International in 1990, he became head of managed futures and options for a major US investment bank in London and founded the Derivative Strategy Group within the ASH Group of Prudential Securities in New York. Cruden joined Tamiso & Co. LLC in 1993 with responsibility for product development and client liaison. During this period he built the firm's interbank currency management activities and co-developed the Currency Overlay Program. In 1999 Tamiso and Man International established a joint venture based around the currency trading system of Tamiso. Cruden established Insch Capital Management AG in Switzerland during 2004.
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