Don’t get rid of hedge funds, get control of them

Everybody agrees that hedge fund investing has to change. For JANA asset consultant MICHAEL O’DEA, these dislocated markets are perfect for investment in hedge funds, but he recommends keeping control through a managed account platform. The situation After the events of 2008, investors around the world have begun to seriously question the merits of investing in hedge funds, which is not surprising when so many failed to deliver positive returns and offered questionable diversification benefits to portfolios when most needed.

It is also quite easy to criticise an industry that for years has been ostensibly self serving, by charging high fees, and paying themselves performance bonuses many multiples of the high CEO salaries of some of the largest companies in the world. The industry as a whole has also been periodically marred by individual high profile blow-ups and frauds (LTCM, Beacon Hill, Amaranth, Bernie Madoff, the list goes on).

In an attempt to differentiate themselves some hedge fund-of-funds claimed to offer access to “investment legends” and marketed their ability to secure capacity in tightly held funds. These claims fuelled a bubble in allocations to some poorly structured hedge funds, while some investors did not have a full understanding of the true risks and liquidity profiles of these investments.

These risks have been made apparent through the recent market environment. Although, in aggregate, hedge funds outperformed traditional 70/30 growth/defensive balanced funds in 2008, hedge funds suffered the worst period of returns ever, understandably disappointing many investors. When one dissects the reasons for this performance it is explainable and even understandable. However, it is another issue to have poor performance complicated by operational problems caused by the structural deficiencies of fund-of-fund and individual hedge fund investment vehicles.

In 2008, largely due to the lack of liquidity, many hedge funds encountered problems. The reasons were varied and disappointing; some suspended redemptions, some closed out foreign currency hedges, others had assets held with Lehman Brothers when it filed for bankruptcy, and more recently the announcement of potentially one of the biggest Wall Street frauds – Madoff ’s alleged US$50 billion Ponzi scheme. Are Hedge Fun ds Dead? While the description so far paints a bleak picture for hedge funds, we are not suggesting investors wash their hands of them.

There are many important lessons to be learned from recent events which, if applied, actually serve to strengthen the case for hedge funds, particularly in today’s environment. The events from the past 12 months have clearly identified where things have got to change but the issues outlined above are surmountable and, in our opinion, hedge funds are worth the time and the effort to get right. We believe that the return potential of hedge funds remains strong.

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