The hedge fund industry began as a nicheprovider of absolute return strategies to the HNW community. That is likely to continue even after the events of 2008. But going forward investors need to do more to avoid the issues of last year.
The recent financial crisis has shaken a lot of complacency out of the alternative investment industry, both from investors and managers. Whilst it is tempting to believe it is ‘back to normal’ as the equity market rallies, many market participants need to relearn some very basic principles of investment that were forgotten in the bull market, particularly with regards to liquidity.
Capital preservation and low correlation to equity markets used to be the primary selling point of the alternative investment industry. When searching for new hedge fund investments, investors could do a lot worse than applying these two simple criteria.
In the rush to gain leveraged exposure to a credit boom meant correlation and capital preservation were often given only token attention.
The exposure a manager personally has to the fund should be a key criterion for fund selection. Whilst there are no guarantees about performance, ensuring interests are aligned should be a minimum requirement.
Understanding the liquidity of investments and how that may change with market conditions is critical for investors. A promise of quarterly liquidity is worthless if the underlying investments in the fund become illiquid in a crisis. When funds cannot liquidate assets to meet redemptions, gates are raised. In order to avoid this, investors must make sure that the underlying liquidity of investments matches the reported liquidity of the fund.
A portfolio of unlisted securities carries far greater liquidity risk than one of listed securities, no matter how it may appear during good times.
Investors need to adopt a more active stance towards their investments, being aware of and monitoring the underlying instruments in the fund. Visibility and transparency will be of greater importance going forward so regular direct dialogue with the manager should be sought.
It is also important such information is independently provided. Bernie Madoff reportedly provided very detailed information on holdings and trading records. But they were entirely fictitious, created from the previous day’s market data. The importance of independent fund administrators cannot be stressed enough and is why the FSA makes this a requirement in the UK.
It is not only what you are investing in that is relevant but who you are investing with. Whilst redemptions have always been a constant feature of collective investments, if everyone exits at the same time there can be immense damage for those investors who take a longer-term view. This issue was particularly prevalent in 2008 amongst funds of funds, many of which had leveraged up client monies to invest in hedge funds. When redemptions were halted in some of the structured credit funds, fund of funds had to redeem elsewhere to raise capital to meet their own redemptions. This triggered a vicious circle of gates and further redemptions across the entire hedge fund industry.
The lesson here was that the ability to take a long-term perspective through the stability of your own capital was not enough. The capital stability of the overall fund is also important.
