Searching for Bobby Fischer

He emerged 20 years later for a victorious rematch with Spassky before disappearing once again. During his first absence, Fischer sightings became legendary. Many people claimed to have seen or even played the champion.

We experienced that Fischer-sighting phenomenon on one of this summer's unbearably hot days when a colleague--always looking for that competitive edge--charged into a meeting proclaiming that long-only management was dead. His most compelling argument was similar to one used by David Swensen, chief investment officer at Yale University and author of Pioneering Portfolio Management. Skillful managers can win on both sides of the portfolio, he said, and should not be limited to long-only strategies.

The ensuing discussion on long-short strategies evolved into a conversation on the merits of hedge funds. We all agreed that several factors have led to an increased awareness of hedge funds in Canada, including lower returns in traditional asset classes, modest future expectations for public markets and an expected increase in correlation for equity markets worldwide.

Like Fischer almost 30 years ago, hedge funds offer the promise of different strategies and strength. Unlike the chess champion though, these strategies will not fade away into the night. Interested parties will need to undertake the type of due diligence on these funds that they have become accustomed to using with more traditional investment strategies.The hedge fund concept is far from new. What is new today, though, is the interest of Canadian institutional investors.

Historical performance data--such as the Credit Suisse First Boston (CSFB)/Tremont hedge fund index or Hedge Fund Research performance indexes (HFRI)--illustrate that these strategies are strong performers with relatively low volatility and a low to sometimes negative correlation with traditional asset classes.

For example, during the last five years ending June 30, 2001, the convertible arbitrage strategy has produced an average net (after fee) return of close to 15%, with a standard deviation in the range of 3% to 4% and negative correlation with equity markets.

The low level of alternative investments in institutional portfolios today reflects the doubts that investors have about this attractive data. The challenge with hedge fund data is that they are subject to reporting and survivor bias (see "Promising statistics" left) as well as inconsistent results among data sources (see "Mixed signals" ). Clearly some questions need to be answered, and this may not be easy given the transparency issues that surround hedge funds.

As hedge fund managers try to accommodate the fiduciary requirements of institutional clients their strategies are becoming more transparent. Despite this, there are still no easy answers to these queries.

For example, losses and risk depend largely on the strategy in question and the skill of the manager. There are many types of strategies--some of them extremely complex--and thousands of hedge fund managers. When you consider that each manager uses his or her own twist for each strategy, the possibilities seem endless. In addition, future returns may be difficult to determine as most industry observers agree that these strategies are not linked to traditional or public markets. As a result, absolute return targets may be more appropriate.

Manager skill is critical to the success of hedge fund strategies and also impacts reported return histories. Managers with great returns are likely to report their returns whereas others may not. This can lead to inflated expectations.

Looking at first quartile fixed-income managers in Canada (and there are a few that consistently beat the index), clients should invest actively and expect returns of about 0.65% above the bond benchmarks. But not all bond managers are created equally and not all hedge fund managers are Bobby Fischer.

It has been said that a few highly publicized failures have unfairly tainted hedge funds, just as some derivative debacles created challenges in convincing fiduciaries of their merits. Many pension plan sponsors had hurdles to cross when they decided to use derivatives. It took time to educate boards, pension committees and staff on the uses, advantages and disadvantages of these instruments.

Derivatives have become an important part of many pension funds. But they only gained this status after systems were set up to avoid the mistakes of others. In the end, plan sponsors that used derivatives did so after writing and implementing detailed policies on leverage, permitted uses, liquidity and other important factors.

The same should be done for hedge funds. Well-publicized failures should not deter investors if these strategies are appropriate in meeting their goals. But those who ignore the lessons of the past do so at their own, and their beneficiaries', peril.

As is the case with traditional asset classes, it is difficult to identify which hedge fund strategies will perform the best in any given year, and the difference in returns between the best and worst performing strategies can be significant. Therefore if hedge funds are used, a reasonable approach is to adopt multiple strategies.

Investors may want to consider a multiple-manager structure to mitigate manager risk. However, most plan sponsors do not have the in-house resources to manage a multi-manager, multi-strategy hedge fund program, and this is where the fund of funds approach comes in. The fund of funds vehicle is the most appropriate for all but the largest pension funds in Canada given the amount of time and resources required to oversee a properly diversified program. But plan sponsors should be prepared to pay for it, and pay big.

Management fees for a single strategy cost between 1% to 2% per year, plus an annual performance charge of 10% to 20% of the total return, sometimes subject to a minimum return. The fund of funds approach can easily add another 1% on top of the annual management fee and take up another 10% of the return.

Put this all together and you could find yourself paying a 2.5% annual management fee, plus 20% of your total return to a hedge fund of funds manager. This is 5.5% if you get a gross return of 15%--definitely something to be considered when determining allocation and performance targets.

As for single-strategy managers, like their private equity counterparts, the good ones do not keep a strategy open for long. They open it up, gather assets quickly and then close. Given their fees, these managers do not need to build a large asset base to put food on the table.

Even if wonderful performance data can be repeated, there is no guarantee that plan sponsors can access the managers responsible for it. Even if these players continue to report performance, it will be meaningless to investors trying to buy in.

There are two implications for investors interested in hedge funds here. First, with a fund of funds approach, it is important for the manager to have access to a pool of hedge fund managers willing to take their money so that your manager will receive the first call when the strategy manager is looking for new money. These underlying managers must be among the best in class. Second, at any given time you will probably not have all of your allocation fully deployed in strategies as funds open, close and mature frequently.

Pension plan sponsors and other institutional investors are always on the lookout for improved ways to manage risk and generate returns. Hedge fund strategies might fit the bill. At the very least, they are worth a second look. Hopefully the next Bobby Fischer is out there waiting to be found. BC