I originally wrote this article for InvestmentNews back in 2008—forever ago, in the financial world. I want to revisit it now for a couple of reasons (and also because I’m kind of proud of it). First, I think it’s held up pretty well and is still applicable, despite all the changes since then. Second, it sets the stage for an extended conversation that’s becoming increasingly important for investors and advisors.
That conversation revolves around expectations—i.e., what are you trying to accomplish with the portfolio?—and risk. We have the standard questionnaires and measures of risk and return, but, based on my frequent conversations with advisors, I’m not sure those tools really capture the dynamics of what’s going on. We need to do better.
Although I wrote this piece about hedge funds, the underlying points apply to any type of investment—and never more so than when prices start to creep up. I’ll expand on the ideas here in the next couple of days, but for right now, over to Yogi.
Yogi Berra on Hedge Funds
In the book Moneyball, Michael Lewis took a detailed look at how baseball managers can use numbers to better manage their teams. Here, I decided to return the favor and ask the Sage of Baseball how advisors can better manage their clients’ portfolios. What follows are my questions, his (appropriately oracular) pronouncements, and my attempts to interpret and apply them. As always, Yogi is right. Any errors are mine.
Q: Yogi, why should we invest in hedge funds? And why now?
A: “I wish I had an answer to that, because I’m tired of answering that question.”
Interpretation: So you want to invest in hedge funds. Why? This is a key question, as the term “hedge funds” encompasses an unbelievable range of assets and strategies, from simple stocks to weather events, earthquakes, life insurance policies, soccer star contracts, and everything in between. Fortunately, there’s a relatively easy and useful way to categorize hedge funds that you can use for your clients.
Is a fund a home-run fund or a steady single fund?
Home-run funds aim to deliver high returns overall, and, like the hitters in this style, they often strike out. High variability of returns usually accompanies a home-run strategy, and even if the overall returns are high, the variability and large losses and drawdowns along the way often scare off many investors. Steady single funds, on the other hand, aim for a consistent stream of returns and as few strikeouts as possible. “Equity returns with bond variance” is the term of art, and it means just what it says.
The answer to the question, really, depends on what you want. Where do you want to go?
Q: Yogi, that’s not much of an answer. Can you expand on it a little?
A: “If you don’t know where you are going, you will wind up somewhere else.”
Interpretation: Hedge funds have two major uses in a portfolio, and if you want to go to either of those places, hedge funds could make sense.
Home-run funds provide a little extra juice in returns. If you’re looking for that, and the portfolio is large enough to allow it, then an investment could certainly be considered now. Now, because hedge funds are based on the idea of continued high returns independent of market cycles, so there should be no need to wait. Home-run funds would work for larger investors with high risk tolerance, or those who want a kicker in a larger diversified portfolio.
If, on the other hand, you’re looking at hedge funds as a portfolio stabilizer, the steady single funds should definitely be considered. Again, now is a great time, as the market is expected to continue at the recent levels of high volatility. Steady single funds, if they perform as advertised, can be good for many types of investors. The smaller drawdowns, combined with steady returns, can work for retirees, those with low risk tolerance, or just as a stabilizing factor for the portfolio as a whole.
Q: All right, so I should consider hedge funds for some client portfolios, and I should do it now. How should I do it?
A: “You can observe a lot just by watching.”
Interpretation: Funds vary a lot—in investment style, in fee structure, and in business structure. All are important and need to be watched.
First, take a hard look at the business of the fund manager. About half of all hedge fund failures are business failures, not investment blowups. Does the manager have the experience to run a business? Is the infrastructure in place? Are reliable professional partners—accountants, lawyers, brokers—in place?
Next, look at the investment strategy. Does it make sense? Is the strategy consistent with the proposed returns? Unlevered utility stocks, for example, probably aren’t consistent with proposed 50-percent annual returns.
Finally, look at the historical returns. Are they consistent with the strategy? Have there been any large movements—down or up? Are the fund’s results consistent with those of other similar funds? If not, why not?
Q: Sounds like we should just stay with the best funds, then, and not try something new and risky.
A: “Nobody goes there anymore—it’s too crowded.”
Interpretation: Everyone wants to get into the best funds. For most investors, though, best usually means “most written about in the press.” Cocktail party bragging rights aren’t the reason to get into a fund.
The other problem is the “magazine cover effect.” If the average investor has heard of a fund, most of the money may well have been made. There are exceptions, of course, but be sure your fund is one of the exceptions. In fact, convincing academic studies have shown that smaller funds tend to outperform larger ones. The reasons aren’t proven but can plausibly include limited market opportunities, decreased manager motivation after they get rich, and other human factors. Another reason is that most advisors and investors simply can’t get access to the largest and best-performing funds.
Q: So if we try smaller funds, how can we pick the best?
A: “It’s tough to make predictions, especially about the future.”
Interpretation: Do your homework. Watching a new asset class unfold, everyone is looking to try new things. Some simply fail, and that should become apparent pretty quickly in their performance.
Others look for an extra advantage. As with the recent baseball scandal, where home-run kings were discovered to be shooting up in the locker room, you need to watch your managers closely. Where did that home-run return come from? Mark McGwire is a lot bigger than most hedge fund managers, but there may be a lot of similarity in their conduct. The incentives for a player—or a fund manager—to cheat can be overwhelming. How can that be controlled? By aligning the incentives. If a hedge fund manager can get rich off a bet or hand the losses to your investor, then heads he wins, tails you lose. How is the manager paid? How much of his own net worth does he have in the fund? How much will he lose if you do? All good questions to ask.
And, after all the due diligence work, funds can still disappoint. Markets change, people make mistakes, pigs occasionally fly. It’s important to diversify at two levels: management and style. Management diversification helps hedge business risk, as discussed above. Style diversification hedges against any one style going out of favor.
Multi-strategy funds (single funds that invest in multiple strategies) and multi-manager funds (or funds-of-funds) are the two roads an investor can go down when seeking diversification.
Multi-strategy funds can diversify style risk well but don’t necessarily hedge against management risk. Another potential shortcoming is whether a multi-strategy fund really has the best managers in a given style overall, or just the best managers it could hire. Funds-of-funds do offer management diversification at the fund level, as well as being free to select the best managers overall. On the other hand, you pay extra fees for that, so it had better be worth it.
Q: Yogi, any final words of wisdom?
A: “In theory, there is no difference between theory and practice. In practice there is.”
Interpretation: Selecting a hedge fund manager is just like baseball—there’s a time to bunt and a time to swing for the fences. At game time, a great manager is just as critical as great players. That’s where financial advisors come in. Your team can include a hedge fund player or players, but they have to be matched to the client and his or her needs. Look at the incentives, look at the expectations, and look at the history.
Most of all, make sure to look at your own abilities to evaluate and manage these assets in the real world. If you don’t feel qualified—in practice, not theory—seek professional advice from your broker/dealer, or consider a fund-of-funds. After all, as Yogi said, “If you can’t imitate, don’t copy.”