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PORTFOLIO
HEDGE FUND ATTRIBUTES
We
typically only allocate client portfolios to funds of hedge funds
(FOHF). However in certain circumstances with clients having substantial
assets we design our own FOHF with significantly lower expense
costs. Many FOHFs have much lower investment minimums (e.g., $25,000)
than individual hedge funds and diversify their exposure to more
than one manager or style. Also, some investors that would be
unable to invest in a hedge fund directly are able to purchase
funds of hedge funds made available by Montecito Capital Management.
"Hedge
fund" is a general, non-legal term that was originally used to
describe a type of private and unregistered investment pool that
employed sophisticated hedging and arbitrage techniques to trade
in the corporate equity markets. Hedge funds have traditionally
been limited to sophisticated, wealthy investors. Over time, the
activities of hedge funds broadened into other financial instruments
and activities. Hedge funds seek superior returns relative to
risk by utilizing a broad spectrum of investment styles, hedging
strategies and financial instruments. The manager generally has
a significant commitment of personal net worth invested in the
fund.
Our
money management firm has rigorously researched pioneering studies
on the impact of alternate investments on portfolios - the results
are no less that startling. The attributes of alternate classes
are lower volatility (risk) and higher returns; indeed, the optimal
portfolio allocation to this class is substantially higher than
espoused by tradition portfolio management doctrine. The performance
and risk return graphs outlined illustrate the risk-adjusted return
benefits of these classes.
What
makes our firm distinctly different from our peers is that we
recognize and have acted on evidence that asset classes and markets
have become more correlated over time. Accordingly, in an effort
to both preserve and grow our clients' assets during even tumultuous
market gyrations, we have relatively high open market mutual hedge
fund exposure to hybrid domestic styles and other traditional
pooled hedge fund positions. We have identified several pooled
hedge fund strategies, that blend the pooled hedge fund styles
that have been consistent top performers year-after-year. What
is unique is that that these products are diversified hedge funds
with liquidity (sell any time), price transparency (track performance),
investability (only $25,000 minimum), stable returns and low correlation
with other assets (volatility is minimized).
Since
we seek to have an assortment of low correlated asset classes
that are optimized to minimize the variation around the target
return (mean), and recognizing that by adding a high risk class
may actually both increase return and lower risk of the overall
portfolio, we capture some of the lowest correlated asset classes
in the alternative investment spectrum. For example, some hedge
fund correlations (for more info turn to portfolio management's
Modern Portfolio Management section) with the S&P 500 by style
are as follows: funds of funds is 0.49, market neutral arbitrage
is 0.40, market neutral hedging is 0.40, opportunity strategies
are 0.65, special situations are 0.65, etc. In particular the
second chart graphically illustrates what low correlated attributes
associated with hedge funds do for an investor's portfolio.
Comparing
Mutual and Hedge Funds
In
addition to the average hedge fund outperforming the average mutual
fund, the highest returning hedge funds significantly outperformed
the highest returning
mutual
funds.
|
Comparison
of the Best and Worst Performing U.S. Hedge Funds and Mutual
Funds1
|
|
Five
Year Net Compound Annual Returns, 1Q98 to 4Q02
|
| |
Hedge
Funds |
Mutual
Funds |
| Top
10 |
34.2% |
27.4% |
| Top
10% |
26.2% |
8.4% |
| Top
25% |
20.4% |
5.6% |
| Bottom
25% |
-1.6% |
-6.4% |
©
2003 by Van Hedge Fund Advisors International, Inc. and/or its
licensors, Nashville, TN, USA. 1 Please see Explanatory Notes
under Legal Considerations section. 2 U.S. hedge funds have been
used as proxy for the universe.
Effect
of Adding Hedge Funds to a Traditional Portfolio Hedge funds,
when added to a traditional portfolio of stocks and bonds, both
improved returns and reduced risk. A traditional portfolio composed
of 60% S&P 500 stocks and 40% Lehman Brothers Aggregate Bond Index
bonds had hedge funds added to it in increments of 10%. The proxy
for hedge funds was the Van U.S. Hedge Fund Index. As more hedge
fund content was added, returns improved and risk (standard deviation)
decreased. The benefits of investing in hedge funds would have
been even greater if superior hedge funds had been used as opposed
to the average hedge fund used in the study.
Return
Risk
Below,
the low correlation between classes are ideal for constructing
a low correlated and low-covariance portfolio which optimized
the mean-variance, placing clients on closest to the efficient
frontier market line given each clients individual return requirements,
risk tolerance and constraints.
For
pure hedge funds, and not domestic hybrid alternatives available
to the public as open mutual funds, we only use funds of hedge
funds. The manager invests in other hedge funds (or managed accounts
programs) rather than directly investing in securities such as
stocks, bonds, etc. These underlying hedge funds may follow a
variety of investment strategies or may all employ similar approaches.
Because investor capital is diversified among a number of different
hedge fund managers, funds of funds generally exhibit lower risk
than do single-manager hedge funds.
The
hedge fund or domestic hybrid open market mutual fund strategies
and styles we prefer are defined below:
Market
Neutral - Arbitrage
The manager seeks to exploit specific inefficiencies in the market
by trading a carefully hedged portfolio of offsetting long and
short positions. By pairing individual long positions with related
short positions, market-level risk is greatly reduced, resulting
in a portfolio that bears a low correlation and low beta to the
market. The manager may focus on one or several kinds of arbitrage,
such as convertible arbitrage, risk (merger) arbitrage and fixed
income arbitrage. The paired long and short securities are related
in different ways in each of these different kinds of arbitrage
but, in each case, the manager attempts to take advantage of pricing
discrepancies and/or projected price volatility involving the
paired long and short security.
Market
Neutral - Securities Hedging
The manager invests similar amounts of capital in securities both
long and short, maintaining a portfolio with low net market exposure.
Long positions are taken in securities expected to rise in value
while short positions are taken in securities expected to fall
in value. These securities may be identified on various bases,
such as the underlying company's fundamental value, its rate of
growth, or the security's pattern of price movement. Due to the
portfolio's low net market exposure, performance is insulated
from market volatility.
Event
Driven - Merger Arbitrage
Manager simultaneously buys stock in a company being acquired
and sells stock in its acquirers, if it is a stock swap transaction
or buys target company in a tender offer. The premium price offer
over the current price is arbitraged as profit as the closing
of the transaction. Efforts are made to determine success of transaction:
regulatory hurdles, financing in place, walk away fees, support
by management and shareholders of both parties, etc.
Special
Situations
Aside from investment strategy, hedge funds may also be categorized
on the basis of the industry sectors in which they invest. While
most hedge funds are diversified among several different sectors,
some specialize in one sector, devoting 50% or more of their portfolio
to such securities. Also, companies' situations are unusual in
a possible variety of ways and offer profit opportunities; e.g.,
depressed stock, event in offing offering significant potential
market, reorganizations, bad news emerging which will temporarily
depress stock (so manager shorts stock), etc.
Distressed
Securities
The manager invests in the debt and/or equity of companies having
financial difficulty. The manager stands to make money on such
a position should the company successfully reorganize and return
to profitability. Also, the manager could realize a profit if
the company is liquidated, provided that the manager had bought
senior debt in the company for less than its liquidation value.
Disclaimer:The information in
this website is based on data gathered from what we believe are
reliable sources. This Web site is intended to give you information,
not investment advice. We do not guarantee its accuracy, nor completeness,
and it is not intended to be the primary basis for investment
decisions. It should not be construed as advice meeting the particular
investment needs of any investor. We may express opinions in this
site and elsewhere about allocating investments between asset
classes. This is NOT a specific investment recommendation to any
person or entity. We do not make 'personal investment recommendations'
to people or entities except to those who have engaged us expressly
for the purpose of providing professional investment advisory
and/or other financial advisory services. The process of making
specific and personal investment recommendations involves a close
understanding of our client’s objectives and expectations. Unless
we have this information, we are UNABLE to make ANY personal investment
recommendations.
