Time to revisit hedge funds ?  

The Business Spectator has some interesting commentary on hedge fund performance - Time to revisit hedge funds?.

Ineichen carved out his reputation as an industry guru with the publication in October 2000 of "In Search of Alpha". That report is said to be one of the most downloaded research reports ever published by UBS.

Ineichen's latest report reviews the hedge fund industry following the financial crisis. It is a mixture of quantitative analysis, philosophy, financial history, anthropology, behavioural science and humour. It is peppered with quotable quotes of investment wisdom.

One of the best quotable quotes is from fund manager Peter Lynch: “Never invest in an idea that you can't illustrate with a crayon”.

Another good one is from Robert Sarnoff, president of RCA from 1918 to 1997: “Finance is the art of passing money from hand to hand until it finally disappears”.

Ineichen, who published his first defence of hedge funds in 1998, has not surprisingly published another lengthy argument in favour of investing in hedge funds.

He says the thing that distinguishes hedge funds from traditional asset management is active risk management.

“This notion rests on the belief that one cannot manage returns, one can only manage risk,” he says. “We further argued that active risk management is a craft; it might involve art but it certainly is not science. The results from active risk management are a function of skill and experience, not market fluctuations.”

Ineichen admits hedge funds have never had it so bad but he rejects the idea that they lost money because the equity market went down. He says hedge funds were victims of the flight to cash.

He estimates that hedge fund assets under management will have shrank from $US1.86 trillion in January last year to $1.07 trillion by the end of this month. These numbers include $500 billion in outflows in the past six months.

The flood of redemptions from hedge funds in the second half of 2008 and the first quarter of this year was mainly the result of retail investors pulling out not institutions. That in itself is a buy signal. He says institutions are back buying hedge funds.

Ineichen says that “based on the vast amount of empirical evidence of private investors buying high and selling low, we cannot rule out that this money will come back”. He warns that based on the recent behaviour of retail investors, some fund-of-fund hedge funds with heavy retail support through structured products were now regarded in the industry as “hot money”.

Sovereign wealth funds are now regarded as the best prospects for investment in alpha strategies.

Before examining the state of the hedge fund industry and the advantages of targeting risk adjusted returns, Ineichen outlined the three overriding themes that are and will continue to impact all investors over the next decades.

“These themes, we believe, will be shaping or re-shaping civilisations. This means it has an impact on the investment landscape and therefore is relevant for all long-term investors. We believe these three major themes to be changes in demographics ("Peak Labor"), a global power rebalancing ("Reverse Pax Americana") and the “Green and Clean” (or “peak energy”) movement,” he says.

The Peak Labor theme draws on an analysis of Japan's aging population and puts forward the theory that the 20-year weakness in its stock market is related to declining productivity from changing demographics.

“So the whole idea of the equity risk premium and the idea that shares always go up in the long term could be regime specific, i.e. a function of population growth,” he says. Declining and aging populations, potentially, could have an appetite for bonds, rather than stocks.”

Ineichen examines three possible short term economic scenarios – reflation, inflation and deflation. He says there is a 70 per cent chance that governments will succeed in reflating the global economy. More importantly for investors, the sentiment in markets shifted in November and December last year. He says capitulation has occurred.

The graphs in the slide show are very revealing. Two stand out. One shows the correlation that occurred between all asset classes in 2008 but hedge funds only fell 20.8 per cent while global equities feel 42 per cent, commodities 62 per cent and real estate 58 per cent. The second graph shows how long it will take for those invested in different asset classes to recover their losses assuming an 8 per cent per annum annual return.

“Large parts of academia and the long-only fraternity of asset management suggest that equities go up in the long-term and that equities beat bonds in the long-term,” he says. “This might be true. However, you might not live long enough to experience the long-term. Risk needs to be managed in the short-term. Short-term survival is a rather important requirement for long-term prosperity.”

Ineichen's conclusion is that hedge funds do not necessarily need the recession to end or inflation not to occur or stock markets to rise. Hedge funds need markets to function normally again.