Hedge fund lessons to learn from storm

Following the economic downturn, the industry has become more institutional and while this is regarded as a positive sign, other developments are more worrying.

Fund managers have become more diligent in reporting risks to their investors.

After the global financial crisis of 2008 and early last year, the hedge fund industry has regained some of its self-assurance, and investor sentiment has improved. As we pause to take a breath and draw a few lessons, what trends have emerged? Two dynamics are clear, although one seems permanent and the other more temporary.

First, the industry has grown much more institutional in nature. After a handful of well publicised frauds, the employment of a third-party fund administrator for valuation and position verification is becoming the norm. It is clear that there is no substitute for a credible fund auditor, a realisation that came too late for some. And, strong risk reporting by funds is now a must, not an option, with investors eager to take stock of their portfolios in increasingly sophisticated ways.

The hedge fund industry and its regulators have also made significant headway on standardising hedge fund due diligence processes and helping industry participants speak a shared vernacular. The US government, for instance, has worked with the industry over the past two years to establish hedge fund investor due diligence best practices, while the UK authorities have recently surveyed hedge fund managers in an effort to develop meaningful risk measures.

Although this institutionalisation is predictable and healthy, other trends are troubling. One of those is the current rush into hedge fund products permitting frequent, potentially heavy withdrawals of investor capital. Investors should not confuse "liquidity" with "safety". Historically, hedge funds have been considered valuable for their potential diversification and return-enhancing characteristics and not as quick and easy sources of liquidity.

Some 2008 fund losses were exacerbated by heavy transaction costs stemming from too much, rather than too little, investor access to capital relative to funds' underlying portfolios. This recent emphasis on full, penalty-free investor withdrawal rights each quarter, month, or even week is worrisome. Overly permissive fund withdrawal provisions can constrain portfolio management in counterproductive ways under normal conditions and, in a future crisis, may spell real trouble for individual funds or the larger system.

A frequent - and correct - argument is that the ability of a fund investor to withdraw his capital should correspond to the liquidity of the fund's underlying portfolio. However, it is important to note that this matching of assets (the fund's holdings) and liabilities (the potential payables to creditors and withdrawing investors) must work both in normal trading periods and during market catastrophes.

Unfortunately, history shows that as the severity of a financial crisis grows, investment positions become harder to exit while demands for capital from lenders and departing investors intensify. Liquidity-focused hedge funds are often forced to hunt for opportunities in the same limited universe of heavily traded investments in order to meet potential withdrawal demands. As a result, they are more likely to hold common investment positions, which can make them more prone to a vicious cycle if some of those funds are forced to sell out of positions in a crisis.

Furthermore, very liquid funds using leverage may suffer from more precarious financing arrangements because their lenders view their less stable capital base as less creditworthy. This in turn increases the likelihood of a fund failure during stress periods, an often overlooked connection between an investment vehicle's equity and debt funding. A hallmark of rigorous risk management is preparation for worst-case scenarios.

Shipwrights build vessels to withstand extreme weather because the alternative is unacceptable. Fund managers and investors can similarly increase their chances of successfully passing through the next financial storm by agreeing on some reasonable constraints on capital outflows from the funds they manage or invest in. Some assume that permissive liquidity is a cost-less feature of an investment product. This is far from true.

Hedge fund managers have correctly adapted their business models to take into account some of the secular shifts that are already under way. At the same time, though, many are earnestly trying not to overreact to what may be more transient changes in industry sentiment, such as the recent emphasis on liquidity at the expense of other equally important considerations. Over time, investors tend to gravitate towards strategies that demonstrate tangible portfolio benefits. For many hedge fund approaches, that added value takes the form of attractive risk-adjusted returns that have modest long-term correlations with equity or credit market fluctuations.

There is no perfect investment solution, and hedge funds are no exception to this truth. After all, in 2008, only a handful of investment approaches produced positive returns, and those strategies will not necessarily work in future market environments. The reason "diversification is the only free lunch" has become a cliche, however, is that it is true. Many investors were initially disappointed with the absolute performance of alternative investments during the credit crisis, but it is now clear that hedge funds were often meaningfully stabilising to investors' portfolios.

This was acutely the case in the Gulf region, where a "passive" investor in GCC equities was down almost 50 per cent across 2008 and 2009, despite last year's rebound. Contrast this with the modest 4 per cent loss achieved over that same two-year span (with far less volatility) by the average hedge fund (as broadly represented by the Credit Suisse-Tremont Hedge Fund Index), and the long-term power of diversification becomes clear.

Today, as investors in the region and elsewhere recover from their initial shock and take stock of their losses, they seem increasingly mindful of the benefits of positive, uncorrelated returns across long market cycles. Hedge fund investors will rightly continue to demand robust institutional controls and infrastructure to protect their investments. They also deserve investment terms that motivate their managers in healthy ways, that provide reasonable access to their capital in view of the objective of the fund, and that are honoured contractually and in spirit.

Hedge fund investors and practitioners mutually benefit when they also agree that attractive returns are most effectively and sustainably generated on a capital base that can remain stable during climates good and bad. Trey Beck is a managing director of the DE Shaw group, which was founded in 1988 and manages approximately US$24 billion (Dh88.15bn) in investment and committed capital