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Hedge funds: An expensive way to match cash returns?

The belief that the higher the risk, the higher the return is untrue!

The latest Fund of Hedge Funds Manager Watch TM Survey by Alexander Forbes contains a very interesting chart, showing 3-year return vs risk, where risk is measured as the standard deviation of the monthly returns over the period.  In other words, risk in this sense shows whether the return was achieved more or less in a straight line (as would be the case for cash) or whether the trajectory included some wild swings, including, possibly if not probably, some negative monthly returns.  The lower the standard deviation, the more cash-like the returns.

Another well-known slogan is that, “The higher the risk, the higher the return” which, no matter how many times it is repeated, remains untrue!  The correct statement is that, “The higher the risk, the higher needs to be the expected return to make it worthwhile.”  Even that falls short, since sometimes the risk of losing 100% of the investment is so high that investment can only be justified on the same basis as a lottery ticket.

However, for the purpose of this article, one would assume, as set out in most textbooks, that the result would be an upward sloping scatter-plot, with the higher risk being rewarded with (generally) higher returns.

Now look at the actual results of the Survey (click to expand chart):

Fund of Hedge Funds Manager Watch TM Survey

A colleague of mine says, “I don’t think I’ve ever seen a data set distributed like that.”  My point is that this study ought to call for a proper investigation of the Hedge Fund industry in South Africa!

Three years ago, it would have been possible to get a fixed deposit with one or other of SA’s leading banks at close to 8.2%. Only three out of the fourteen funds in the survey were able to beat that – and not by much. Within that group, though, there is considerable difference in the way that the returns were achieved. The standard deviations were, respectively, 1.5%, 3.5% and 6.5%.

A further look shows that the group (of three) with the lowest risk produced returns above 7%, whereas the worst returns, of less than 4.5%, were associated with risks of 3% and 4%. 

If one were to use this past history to make informed decisions about where and how to invest in a hedge fund in SA, it would surely be sensible to choose the ones (whatever their actual mandate) that have shown the lowest variability in returns. That, naturally, means that investors ought to compare those with a meaningful alternative, namely cash (or a fixed deposit).

The fact remains that, based on these results, investors should be very careful in deciding whether the return promised and any promises about protecting capital are worth the fees charged, when there are meaningful alternatives readily available.

Liston Meintjes is portfolio manager at NVest Securities.

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How the hedge fund industry has been allowed to get away with such outrageous fees is an indicted on the FSB and other authorities. Many investors in hedge funds (such as ordinary retirement fund members) are not ‘qualified (or wealthy) investors’ yet must pay these ridiculous fees. However, the tide is turning and the hedge fund industry must play ball and reduce fees or face the withdrawal of billions.

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