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Why are they called hedge funds?

The last few months has once again put the spotlight on the hedge fund industry. Over the last few weeks speaking to investors, we are hearing horror stories reminiscent of many we heard back in 2008. Some hedge funds were down -60 and -90 percent and even a well know fund of fund was off -20 percent. As we should know by now, most hedge funds are not really hedged that much, and some not at all. Academic studies have shown, that as an asset class, hedge funds on average have about 50 percent of the beta of the market with about 2% alpha. So when the market is down -20%, historically hedge funds deliver around -8% and about +12% when the market is up +20%.

The question that confronts many investors is “why must we pay 2 and 20 fees on investments with so much imbedded beta”. The industry answer is that you get access to some truly gifted managers and those gifted managers are less encumbered within a hedge fund structure that allows them to access investment “tools” that are not available in most typical long only fund structures.

There are many equity hedge, market neutral funds tracked by HFR, Inc that do hold up during these more turbulent periods but deliver on average very low, non-correlated single digit annual returns. There are a few other funds, that will take on more active risk but also remain market agnostic. These funds hold up well during periods of market stress but also tend to have a much higher non-correlated expected return profile. An example of one such fund’s portfolio performance since the market high of Feb 19 thru May looks like this:

 

Even before the recent “stress test” in the market, hedge funds in general had begun to loose much of their luster. As reported in a recent report by Preqin (below), hedge fund performance has been somewhat underwhelming even by hedge fund standards.

In assessing hedge funds, investors need to be able to evaluate them on a number of key metrics:

What is the expected return (alpha) of the strategy?
How is risk defined and what is the source of risk?
Relative volatility
Leverage
Market related or idiosyncratic
How non-correlated are the returns?
How liquid are the underlying positions?
What is the value proposition?
Are you paying hedge fund fees for beta?

Lastly, investor should consider the “scalability” of a strategy or fund. There is strong evidence that there is a persistent excess return in many more niche or focused strategies. These strategies include high conviction or best idea strategies, sector or asset focused strategies. Most of these funds will have limited capacity, as such, allocators need to consider investing in the early years of these funds as they tend to close to new capital as they approach their optimal A.U.M. size.

About Monomoy Point Capital Advisors. Monomoy Point manages the B.T. Alpha Fund, L.P. a high conviction (about 20 positions) biotech fund, hedged to the biotech industry. For more information please email:

 

r.potvin@monomypoint.com

Bob Potvin
r.potvin@monomoypoint.com
1460 Broadway, 8th fl.
New York, NY 10036
617.306.7853

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