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Beyond the equity market

By Neville Bennett

Friday 11th July 2003

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The hedge fund industry has grown explosively in the last few years. This is because other asset classes have performed relatively poorly.

The market has also responded to a product that was previously a vehicle for the rich. Their performance has been generally good and it can be claimed that they can deliver "stock-like returns with bond-like risk."

It makes sense to add them to one's portfolio. A good rule of thumb is 10%, a conservative allocation. The rich tend to go higher.

Nevertheless, the choice of a good avenue is a matter of concern. The total amount invested in hedge funds is about $US400 billion ­ small beer compared with the $US25 trillion reputedly invested in equities.

It is hard for hedge funds to increase in size, as managers could not operate on the scale that equity funds do. There may be a risk that new entrants to the hedge fund market do not perform as well as proven managers.

If so, a bipolar world may emerge with an elite of top managers and a rather mediocre mainstream. Some managers will be driven out. The investor must accept these dynamics and be careful to avoid over-exposure to one particular fund. As ever, moderation is a good guiding principle.

The appeal of hedge funds is not merely a question of performance. It is philosophical. Most equity funds pursue "relative returns." This means, basically, that managers will try to beat their competitors. This was fine until the bear market revealed relative managers were quite happy for their fund to decline 20% as long as most of their competitors had a 21% decline.

When challenged, these managers assert losses in the short term do not matter, as stocks will always grow faster than other assets in the long run.

In contrast, the managers of hedge funds pursue "absolute returns." This means their aim is to avoid losses, and that the preservation of capital is a paramount duty of the manager.

The fee structure reflects this. Many funds do not exact any charges on a declining portfolio but they do exact a healthy charge on profits.

In the past week I interviewed members of perhaps the longest established fund. I should add two points of clarification. First, I have made a point of never using a press release, and never trying to write "news." I have not previously interviewed anyone for this column in 12 years: I rely on analysis.

Second, although I did an exclusive interview with GAM, nothing I say constitutes a recommendation. I would prefer readers did not invest with it, unless the reader had done extensive research first and arrived at an independent decision. As it happens, I am fully committed to other hedge funds and I am not looking around for alternative exposure.

I interviewed the GAM visitors out of an academic sense of inquiry. I wanted to know how they think. Do they have any smidgen of relativist feelings? How do they assess risks? Are they really concerned with preserving capital?

These are questions worth pursuing, as there are few operators in the New Zealand scene.

GAM is the oldest manger of funds of hedge funds. It is the biggest fund in the world of its type, with $US12 billion under management. It could not invest a quantum of this magnitude in its own funds.

Instead it constantly looks around the world for hedge funds in which it can invest. It does this well. It claims to have swept the pool in awards last year: I spent some time in checking up on that claim and am satisfied that it is correct.

Josephine Shaw and David Lam are Hong Kong-based. They explained their fund was aimed at asset diversification: hedge funds add another asset class to portfolios.

I warmed to them when they remarked they would not invest with a manager they had not personally met: it is a trait found in Asia and seems admirable. They are not just interested in performance: they look at the books and try to work out if the manager is merely an "asset gatherer" or someone who really adds value.

A manager who makes the grade becomes a "building block:" he is only one of about 100 managers employed. GAM has several strategies, some of which are too complicated to expound in a brief article. But a common theme is the reduction of volatility and the preservation of wealth.

Some funds are in "alternative investments" that take positions in commodities, currencies and interest rate options. Readers may recall a previous mention here of Tower's GAM Multi-Trading Fund, which has posted an average annual return of 12.2% for the last seven years. It is an example of the returns available outside of the equity market.

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