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Oct. 14, 2011
Wealth in an uncertain age
Hedge funds have the ability to walk off with prize trophies.
ARI SHIFF
How do you build wealth when the “buy-and-hold” stock investment strategy that worked well for the last 20 years may no longer be effective? Many experts believe that for the next several years “alternative investments,” such as hedge funds, which have historically shown a lower correlation to stocks and bonds, may be less risky and more rewarding.
Hedge funds were invented in the 1940s to take advantage of the fact that stocks don’t always move upwards. While most traditional investment managers and mutual funds are restricted to “going long,” or only making money when an investment goes up, hedge funds have the ability to “go short” and make money from downward movements as well. During periods of extreme volatility, combining both strategies, with the aim of making a profit if the market moves in either direction, can be particularly beneficial.
Hedge funds have the ability to invest opportunistically around the world, with fewer of the restrictions placed on long-only and mutual-fund managers, who often manage larger pools that are harder to navigate in difficult markets. That freedom has been critical to hedge funds’ strong performance and their ability to profit in the post-2008 world, where substantial assets have lost their natural investor base through downgrades, defaults or loss-of-growth prospects or dividend-yield.
The Sept. 27 page one Wall Street Journal article “Pivot point: Investors lose faith in stocks” detailed how investors are abandoning stocks because they believe the extreme volatility we’ve seen over the last few months is here to stay, a legacy of the housing bubble and financial crisis of 2008-9. Indeed, since June of this year, investors have pulled out more than $100 billion from stock funds, an amount greater than was invested since the stock market bottomed in 2009.
Unfortunately, the bond market is not doing much better. With interest rates expected to remain at historic lows for years to come, bonds (at their lowest rates since the 1940s) and cash instruments will barely produce enough real returns for investors to tread water. Faced with such a weak economic outlook, smart investors are seeking less correlated alternative investments to diversify their portfolio so that they may instead benefit from the same macro-economic conditions that are bedeviling stock and bond performance.
Beyond trading just stocks or bonds, hedge funds can trade in the equities, currencies, commodities and trillions of dollars of mortgages, loans and sovereign debt that have now been orphaned by the banks, insurance companies and proprietary trading desks no longer able to hold these assets.
History teaches us that when volatility is high, tactical traders can be well rewarded by the market for sorting through the rubble and repositioning assets (aka: buy low, sell high). With fewer investors and less credit now available, underappreciated but intrinsically valuable assets are available in many markets. Add to this the investment opportunities that historically follow government interventions, now multiplied by the number of countries that saw their economies shaken to their roots in 2008. Countries as different as the United States and China (not to mention France and Germany) are now participating in large-scale interventions requiring unprecedented coordination. Hedge funds, with their ready access to capital and ability to deploy and change direction quickly, have the firepower to walk off with some prize trophies.
But how does one identify which hedge fund managers are likely to fare the best? Over the last five years, the market provided a natural stress test that forced managers to remain nimble and anticipate the unexpected. Each of the past five years had very different conditions. The laggards fell by the wayside and the survivors who proved their talent – their ability to detect opportunity and their skill at controlling risk – are now having their day in the sun. The hedge-fund universe now comprises more than 10,000 funds. But only a handful show the skill, flexibility and fiduciary duty that will likely result in superior returns and responsible relationships with investors.
Happily, combining superior funds into a diversified portfolio of funds can potentially produce even better returns, with less downside volatility and less correlation with the stocks and bonds typically found in a Canadian investor’s portfolio. Just as a prudent stock investor would not invest all his money in a single stock but would create a basket of stocks to benefit from multiple exposures, a prudent hedge-fund investor invests in a “fund of funds,” a basket of hedge funds with fundamentally different opportunities to benefit from many different market exposures. Moreover, a fund-of-funds manager has the ability to dynamically add or reduce exposure to a particular strategy, collectively managing risk and diversification and potentially producing market-independent returns – a very important control to have during periods of extreme volatility.
As Canadians, we are more fortunate than our cousins south of the border in that we have enjoyed the benefits of a long currency and commodity boom. Now that the boom is starting to wane in the face of slowing growth in Asia and elsewhere, it appears to be an opportune time to take gains off the table and create generational wealth through the kind of asset diversification that can be achieved by expanding a portfolio to encompass more tactical and globally focused sources of potential profit.
By diversifying into a fund of hedge funds, investors can break free from the boom/bust cycle plaguing stagnant equity portfolios, and may well find they are able to improve both their overall returns and their peace of mind.
Alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. Past performance is not necessarily indicative of future results, so you should consult with your professional advisor before making any investment.
Ari Shiff is the founder and head of research of Inflection Management Inc., and manager of the Inflection Strategic Opportunities Fund. Shiff has more than 15 years experience in hedge funds and can be reached at [email protected] or 604-730-9147.
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