In defence of hedge funds: Institutional investors are giving a vote of confidence

THE latest hedge fund performance figures show the average fund was down nearly 5 per cent in 2011, and have prompted some to say: “The hedge fund model is broken”.

It is worth noting that global shares, according to the MSCI All-Country World Index, were down 9.4 per cent in 2011, but nobody is arguing that the joint-stock company model is broken. And no-one would argue that the mutual fund model was broken, either, after one bad year.

2011 was a bad year for the global hedge fund industry, but many managers and strategies did well in very difficult circumstances.

It was also not so much a bad year, as a bad third quarter. The industry was down 7 per cent in the third quarter, when the EU sovereign debt crisis was raging, but up for the rest of the year.

It is worth putting 2011 in context as one of three down years in the last 20 for the global hedge fund industry. During 1999-2010, the major hedge fund indices averaged overall returns (after fees) of more than 8 per cent per annum.

Investors continue to express confidence in the industry. Barclays Capital has just put out a report saying that investors may add about $80bn (£51.78bn) of net new capital to hedge funds globally in 2012, the most since 2007. More than half the investors surveyed by BarCap plan to increase their hedge fund investments in the coming year, more than seven times the number that plan to reduce their allocations.

This may be because many strong managers with excellent performance-to-risk track records have continued to succeed in a harsh investment environment. And even those with poor results this year can often point to many years of success before this one.

It is also because hedge funds can provide an important source of diversification for many investors. Pension funds have traditionally invested a large part of their portfolios in stocks and bonds, but there are now question marks hanging over the risk/return characteristics of both as a result of the sovereign debt crisis and concerns over the outlook for corporate profitability and growth.

Indeed many investors actually see hedge funds as a port in the storm. At least in theory, in a volatile and uncertain world, an investment manager who is active and who can hedge, which is to say, one who can offer protection on the downside, ought to be well placed to navigate the stormy weather we're seeing right now.

Historically, hedge fund returns were achieved with considerably lower levels of volatility than equities, indeed only slightly above bond levels, and with higher returns than for bonds.

That ability to reduce volatility is one significant positive for hedge funds. Another is avoiding big draw-downs. Of course the industry suffered in 2008 and 2011. But it out-performed global equities in both years.

Avoiding big draw-downs is extremely significant if you look at returns over a long cycle. If your manager can hedge, ie if they go short as well as long, they can prevent the worst of those losses. If they cannot, they are totally exposed to the vagaries of the market.

The figures from American university endowments, who have been enthusiastic investors in hedge funds, show the benefits of investing in hedge funds over the long-term. Take Harvard and Yale, for example. Their hedge fund investments returned 8.9 per cent and 11.8 per cent respectively annually over the last ten years, including down years. The latest annual figures (to mid-year 2011) show that the University of Virginia’s hedge fund portfolio was up 16.3 per cent; Yale’s was up 12.7 per cent; the University of Texas System was up 12.5 per cent; the University of California up 12.3 per cent, and Harvard up 11.6 per cent.

Prominent British institutional investors in hedge funds include USS (the Universities Superannuation Scheme), which has a hedge fund portfolio valued at more than $1.2bn that is expected to double in the next year, and BT Pension Scheme Management, one of the largest pension fund investors in Europe in hedge funds.

University endowments and pension funds are among the institutional investors who now account for a significant majority of the assets under management globally for the hedge fund industry (more than 60 per cent, according to Preqin). That is a big change, because even a few years ago, the majority of the industry’s investors were still high net worth individuals.

This change in the investor base, often called the “institutionalisation” of the industry, has been a game-changer. Institutions are socially valuable because they are guardians of investments on behalf of the man in the street. They are exceptionally serious in terms of due diligence and demand appropriate risk management, governance and regulatory compliance from the investment managers and funds to whom they allocate. That institutional investors are confident in the abilities of the hedge fund industry to negotiate the current stormy weather is a tremendous vote of confidence.

Andrew Baker is the chief executive of the Alternative Investment Management Association (Aima).

Investment managers who can hedge ought to be well placed in today’s storms