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Article taken from:

Quarterly Bulletin
Winter Edition
January 2010

Hedge funds - an improving outlook

There is an enormous number of hedge funds in the world, with a large amount of variation in terms of strategies, risk factors and the degree of hedging employed. We believe that any hedge fund worthy of its label should seek to make most of its
performance (and take most of its risk) in individual events or opportunities. This means selecting its investments and managing risk in such a way that its performance is not dependent on movements in the market as a whole.

One strategy, equity long-short investing, serves as a simple example of this. The fund buys (‘goes long’) stocks it believes are under-valued and sells short1 stocks it believes will go down. In addition to doubling the ways a hedge fund can make money compared to a traditional ‘long-only’ equity manager, short selling helps
to neutralise the broader stock market risk, thereby reducing risk and increasing the risk-adjusted return.

The graph below illustrates the performance of hedge funds in general, compared to the US stock market. From 31/12/1989 to 30/11/2009, a theoretical $100 invested in the HFRI Fund of Funds Composite Index (net of fees) would be worth marginally more than if it had been invested in the S&P 500 Index (total return, excluding fees).
More importantly the HFRI return was achieved with significantly lower volatility (ie lower risk).

There are of course several ways to gain hedge fund exposure, including offshore funds; UCITS III2 hedge funds; listed investment companies; and funds of hedge funds. Some of their relative merits are discussed below.

The majority of hedge funds are based in offshore locations such as the Cayman Islands, Bermuda and Dublin, in order to avoid paying taxes on their profits (which would be in addition to the taxes investors may pay on gains on their own investments). The downside to the UK investor however is that any gains are taxed as income rather than capital gains.

A growing number of hedge funds are being established onshore in Europe (designed to fit within the so called ‘UCITS III directive’). They are much more liquid than offshore funds, usually having daily liquidity whereas offshore funds will typically have monthly or quarterly exits with long notice periods, ranging from 30 to 90 days.

However, this ‘liquidity’ advantage actually creates one of the key disadvantages of UCITS III hedge funds as it necessitates highly liquid underlying positions. The UCITS rules also limit the amount of exposure they can take. These factors reduce both the opportunities and strategies available to them and their profit potential. The investor is, as a result, investing across a smaller number of strategies, which clearly does not aid diversification.

At present, we believe that the outlook for hedge fund strategies is more positive than for some time, regardless of the fund’s structure. Competition for opportunities has dramatically reduced following 2008 as the number of hedge funds has fallen and banks have closed down their own proprietary trading desks. Indeed, many hedge funds have achieved some of their best returns this year, and we see strong potential for the favourable environment to continue. Here at Principal, we gain exposure to hedge funds for our clients, where appropriate, by means of our own
offshore fund of hedge funds, Principal Absolute Alpha Portfolio IC, and carefully selected individual UCITS III funds.

Notes

1. Short selling involves borrowing stock from a lender and selling it at the current market price for cash. At a later date, the manager buys the stock in the market and returns it to the lender. If the price he pays is less than the price at which he previously sold it, a profit will be made.
2. UCITS: Undertakings for Collective Investment in Transferable Securities.