In the aftermath of the subprime mortgage meltdown in the U.S. came the news that certain fixed-income based hedge funds had sustained significant losses or in some cases collapsed. Now it seems that many pension funds are revisiting their allocation to this “asset class”—eager perhaps to “buy high, sell low” or fearing that the attraction of hedge funds is over.
What are hedge funds? Despite the intriguing name they do not hedge liabilities. A wise man once observed that “the only perfect hedge is in the Emperor’s garden in Japan.” But hedge funds were never intended to behave the same way as liabilities under all or even most market conditions.
Do hedge funds allow investors to “hedge their bets”? In a manner of speaking, they do. They are sources of “alpha,” return due to skill or arbitrage, which is usually uncorrelated with “beta,” return due to the general market. So hedge funds may go up when markets go up, or go up when markets go down. But unlike a horse race, where you may “hedge your bets” by betting on all horses at the same time, thus ensuring a win, hedge funds do not guarantee a favourable outcome. They may win or they may lose.
The most common form of hedge fund is a long-short strategy, where the investor “bets” on a manager’s stock selection skill and uses leverage(the “short” position)to enhance the bet without deploying much capital. A similar strategy may be used in the fixed-income world, based on credit selection skills, with subprime mortgages being the chosen asset. A savvy investor, given the state of the credit markets earlier this year, with credit spreads significantly tighter than long-term averages, might have preferred to take the opposite view. This would have entailed a “long” position in the high quality credit and a “short” position in the low-quality credit.
The downside to this position would have been the “cost of carry”—the spread paid on the “short” position would exceed the spread received on the “long” position. But the capital gain when spreads widened, as they inevitably would, would be intoxicating.(A brilliant investor would put on such a position just before spreads widened.)
This position might be viewed as a form of hedge, as it would offset credit exposure in the traditional fixed-income portfolio. However a hedge fund investing in subprime mortgages on a leveraged basis was a “risky” asset, not a “matching” asset and should have been viewed accordingly. One should also have questioned whether the manager truly understood the risk they were taking, given the lack of transparency in this market.
In fact, most hedge funds are “risky” assets, despite their reassuring name. They would be more appropriately called “alpha” funds. They may provide uncorrelated risks and returns to those of traditional assets, but unless those risks are transparent and well understood by the investor, the “returns” may come as a nasty surprise.
This doesn’t mean that investors should shun hedge funds when the returns are more modest. If there is reason to believe that the skill or arbitrage is sustainable, then proceed with customary caution. However, the “emptor” should “caveat”—be aware of the risks being assumed, assume them knowingly and then hold steady with confidence when the going gets rough.