Friends, Romans, Countrymen… Don’t Give up on Hedge Funds!

05.19.2021 - Douglas Cohen, Portfolio Manager

With just a bit of nod to Marc Antony in Shakespeare’s Julius Caesar, we have often come to bury hedge funds, not praise them. Over the years, we have pointed many folks to Simon Lack’s 2012 book The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, with perhaps its bottom line: “If all the money that's ever been invested in hedge funds had been in treasury bills, the results would have been twice as good.” But is that indictment truly definitive or maybe a tad overstated, especially with so many fixed income investors currently in search of yield?

Hedge Funds Have Seemed Unattractive for Some Time . . .

Simon Lack is a former member of JP Morgan’s investment committee who allocated over $1 billion to hedge funds during his time at the firm. His conclusions are that hedge funds are generally far more rewarding for those who run them than they are for investors given their high fees, illiquidity, tax inefficiency, tendency to herd into the same trades, persistent lackluster (at best) equity shorting capabilities and poor disclosure. In Lack’s view, the hedge fund glory days ended in the 1990’s as too many funds ultimately began chasing too few good ideas. He cites the survivorship bias[1] that skews aggregate return data while recommending only a modest allocation in one’s portfolio to a handful of emerging managers who are implementing truly new and differentiated strategies.

. . . But Low Fixed Income Yields May Raise Their Appeal to Some Investors

Much like Antony at Caesar’s funeral, we could probably fire up the masses with all the evidence that Lack and others have amassed highlighting the shortcomings of what is often described as both an investment vehicle and a compensation scheme. Above all else, why would one pay the steep management fees often associated with hedge funds to a manager with a perpetually long-bias that largely mirrors the exposure of a true long-only fund with far lower fees and daily liquidity? Yet, just as Antony ultimately pivots to provide Caesar’s mourners with a more positive perspective, we will do the same. Simply put, the likely returns for fixed income over the coming years are so uninspiring that we believe that a basket of hedge funds tilted toward low betas, low correlations and a true absolute return orientation[2] can serve as a worthwhile substitute for a meaningful fixed income portion of the traditional 60% equity/40% fixed income portfolio.

Our Approach to Hedge Fund Investing

We have tilted most of our favored hedge fund ideas over the last few years to those that we believed could generate a significant return above Treasury bills with a limited relationship to traditional asset classes. As a result of our approach, we think of the hedge fund allocation more as a complement to fixed income and cash than a defensive equity-like allocation or “equity-like return with less volatility.” We emphasize whether a given manager can meet our objective in a fashion that reflects our investment philosophy.

When we find a manager that appears intriguing, we emphasize understanding the firm’s people and the culture—along with a heavy focus on their investment process and how repeatable it is likely to be over time. From there, we try to form an ex-ante expectation[3] for how and why a given strategy is likely to perform in different environments. Upon completion of our standard due diligence process, we typically invoke Jim Collins’s Built to Last in which he refers to a “fire bullets then cannonballs” approach toward position sizing. That approach typically results in small initial position recommendations followed by larger ones as long as the manager appears to be executing on our expectations for their strategy and process.

Perhaps a Premature Funeral?

Just as Marc Antony stated a need to pause at Caesar’s funeral, so we would suggest that such a moment is required when considering hedge funds in light of today’s ultra-low interest rates for fixed income. For traditional portfolios, these non-traditional investments may now offer at least a partial solution to the challenges that a 40% fixed income allocation faces for investors. We believe that careful analysis and a disciplined evaluation process can identify attractive hedge fund managers.

[1] Survivorship bias is the tendency to view the performance of existing funds in the market as a representative comprehensive sample without considering those that may have gone out of business.

[2] A low beta value typically means that a stock is considered less risky but will likely offer low returns as well. Correlation is a statistic that measures the degree to which two securities move in relation to each other. Absolute return differs from relative return as it is concerned with the return of a particular asset and does not compare it to any other measure or benchmark.

[3] Ex-ante refers to future events, such as the potential returns of a particular security, or the returns of a company.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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