Because of the market volatility of recent days, determining which hedge funds will perform well is as difficult a task as it has ever been.
To help with that, and in recognition that pitchers and catchers are due to report this week, we turned to the collective wisdom of baseball sage Yogi Berra for some advice on how to manage portfolios better.
What follows are my questions, Yogi's (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?
A: I wish I had an answer to that, because I'm tired of answering that question.
Interpretation: This is a key question, as the term "hedge fund" encompasses an unbelievable number of assets and strategies. Fortunately, there is an easy way to categorize hedge funds.
Is a fund a home run fund or a singles fund? Home run funds aim to deliver high returns; like the hitters in this style, they often strike out.
A home run strategy is usually accompanied by high variability of returns, so even if the returns are positive, the variability, large losses and drawdowns scare investors away. Singles funds, on the other hand, aim for consistent returns and as few strikeouts as possible —"equity returns with bond variance."
Thus, the answer to the question depends on what you want and where you want to go.
Q: That isn't much of an answer. Can you expand on it?
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. Home run funds provide a little extra juice in returns.
If that is what you are looking for and the portfolio is large enough, consider an investment now.
Because a hedge fund seeks continued high returns independent of market cycles, there is no need to wait. Home run funds may work for larger investors with high risk tolerance or for those who want a kicker in a larger diversified portfolio.
If, on the other hand, you are looking for a portfolio stabilizer, consider singles funds. Because they have smaller drawdowns and seek steady returns, they may work for retirees or those with low risk tolerances.
Again, now is a great time, as the market is expected to continue its recent high volatility.
Q: OK, if I consider hedge funds and I 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, and in fee and business structure. These characteristics should be watched.
First, look at the fund manager's business. About half of hedge fund failures are business failures, not investment blowups.
Is the manager experienced enough 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 it consistent with the proposed returns?
For instance, utility stocks that haven't been leveraged are probably not consistent with proposed 50% annual returns.
Finally, look at the historical returns. Are they consistent with the strategy? Have there been large movements — down or up? Are fund results consistent with similar funds?
Q: It sounds like we should stay with the best funds 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. To most investors, however, "best" usually means "most written about in the press."
Cocktail party bragging rights are no reason to get into a fund. Anyway, if the average investor has heard of a fund, most of the money may already have been made.
There are exceptions, of course. Persuasive academic studies have shown that historically smaller funds have tended to outperform larger ones.
Reasons may include limited market opportunities, decreased manager motivation after becoming wealthy and other human factors.
Also consider that most advisers and investors can't gain access to many of the largest and best-performing funds.
Q: 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. Everyone looks to try new tactics when a new asset class unfolds. Some funds simply fail, which becomes apparent quickly in their performance. Others look for an extra advantage.
Like home run kings who were discovered augmenting their performance with drugs, managers should be watched closely. Where did that home run return come from?
Incentives for players — or fund managers — to cheat can be overwhelming. How can you manage the risk?
Align 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 or her own net worth is in the fund? How much will he lose if you lose?
And, after all the due diligence, funds can still disappoint. It is important to diversify at two levels: management and style.
Multistrategy funds and multi-manager funds, or funds of funds, are two roads to take when seeking diversification. Multistrategy funds diversify style risk well but don't necessarily hedge against management risk.
Another potential shortcoming is whether a multistrategy fund has the best managers in a given style overall or just the best it could hire.
Funds of funds, on the other hand, offer management diversification and are free to select the best managers overall. You pay extra fees, however, so it had better be worth it.
Q: 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 like baseball — there is a time to bunt and a time to swing for the fences. At game time, a great manager is as critical as great players. That is where financial advisers come in. Picking your team can include a hedge fund player, but your choice must be appropriate for the client.
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Brad McMillan is the director of alternative investments at Commonwealth Financial Network in Waltham, Mass. He can be reached at bmcmillan@commonwealth.com.
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investmentnews.com/investmentstrategies.
