HEDGE FUNDS: Worth A Closer Look?

Until recently, corporate asset allocation rarely included hedge funds as a component. One reason was the lack of meaningful benchmarks. Fledge funds - essentially, private pools of capital targeting wealthy individuals and institutional investors - were difficult to categorize within traditional asset allocation models. Another problem was the secrecy surrounding hedge fund holdings.

Getting hedge fund managers to share detailed information on their portfolio positions was an arduous task. In addition, many of the hedge funds most commonly employed by institutional investors were dubbed "market-neutral," purporting to out-perform traditional conservative U.S. Treasury fixed-income markets while limiting portfolio exposure to equity market fluctuations. But these funds were not meeting their objectives and appeared to be heavily correlated to underlying equity markets.

Much has changed. As an asset class, hedge funds outperformed all others during 2000. While the Dow, S&P 500 and Nasdaq dropped 6, 9 and 39 percent, respectively, the average hedge fund rose 8 percent. And the positive performance continues: For the first four months of 2001, the CFSB/Tremont hedge fund index was up 1.53 percent.

The benchmarking issues that once deterred many institutions from embracing hedge funds are slowly being swept away, thanks to new indices from Hedge Fund Research, Goldman, Sachs & Co., CSFB/ Tremont and Morgan Stanley Capital International (MSCI). With benchmark obstacles abating and equity markets continuing to whipsaw in 2001, "market-neutral" or "absolute-return" hedge funds have emerged as an option worth considering for corporate portfolios, provided the true absolute-return hedge funds - i.e., those uncorrelated to underlying markets - can be identified.

According to hedge fund advisor Hennessee Group, hedge funds have outperformed domestic stock mutual funds in 12 of the past 14 years. Institutional investors now make up roughly 25 percent of hedge fund assets, up from only 5 percent in 1993, according to Cerulli Associates. Reuters recently reported that while individuals still account for 54 percent of total hedge funds assets, "corporations now appear to be the fastest-growing source of capital."

Greenwich Associates, a research and consulting firm, notes that corporate pension funds, public funds and endowments have all increased their use of hedge funds strategies since the firm's first surveys on the topic in 1998; that growth is expected to continue. The latest survey indicates that 45 percent of endowment funds with assets of more than $1 billion use hedge funds, with another 9 percent expected to begin using them this year.

Among corporate pension plans, 17 percent with assets above $5 billion use hedge funds, while another 7 percent anticipate hiring a hedge fund manager. Overall, 11 percent of the 1,374 funds interviewed already use hedge funds, versus 9 percent in 1998; another 3 percent are starting to use the funds in 2001.

The attraction of hedge funds is their promise of diversification and the reduction of overall portfolio risk. While these hybrid investments trace their roots to the 1950s, modern hedge funds can be any type of private partnership with investment mandates that can include anything from simple long equities, to esoteric derivatives, to global macro strategies. The term "hedge funds" is actually a misnomer. Most do not truly hedge, but use a variety of trading strategies to limit market exposure.

Hedge fund managers are free to use strategies unavailable to mutual fund managers and employ much greater leverage within their portfolios because they are not subject to the stringent regulations that govern mutual funds. Because of this, some financial executives regard hedge funds as being riskier than mutual funds, but that's often not the case.

Hedge funds with true absolute-return characteristics carry risk comparable to a conservative U.S. Treasury fixed-income strategy, but with returns comparable to a conservative long-only equity strategy. While performance is not correlated to the markets, the funds can and do have losing months, and there is no assurance they will outperform the markets for any specified time.

What true "absolute-return" means is that performance is independent of the markets, and that's a critical distinction. The reason many so-called absolute-return hedge funds fall short of their objective is that the securities in their portfolio lack a discernable convergence, the key to absolute-return performance.

Dimitri Sogoloff, principal of New York-based Alexandra Investment Management, says, "There are a lot of fund managers who try to buy undervalued stocks while simultaneously selling stocks they deem overvalued. It's a valid strategy if a link exists between the two groups. But most of these funds hold stocks with no real relationship or interconnectivity; they are typically companies within the same industry or ones that share some similarities, but that does not constitute convergence. They are merely a collection of stocks the fund manager believes may go up or down."

Sogoloff explains that a true absolute-return hedge fund contains securities with a contractual interrelationship. One example would be a convertible security, a fixed-income instrument with an equity component. The fixed-income portion (principal payable at maturity and coupons throughout the life of the bond) is a debt obligation of the issuing company, and failure to pay it would likely force the company into bankruptcy.

Conversion Value

In any company's capital structure, convertible securities and their debt obligations hold a position senior to that of common stock. In addition to their value as fixed-income securities, another feature adds to the attraction of convertible bonds: they may be converted into a fixed number of shares of the issuing company. This conversion right gives a convertible security a "conversion value" equal to the market value of the shares obtainable from conversion of the bond.

Most convertible securities trade at a premium to their conversion values, due to the incremental value of their fixed-income obligations. Additionally, as the price of the common stock fluctuates, so does the conversion value of these securities. In this manner, the market continually prices convertible securities, based on their conversion values plus the incremental value of their fixed-income components.

The current environment of falling interest rates could hardly be better for convertible arbitrage strategy. Convertible arbs have been among the top-performing hedge funds, gaining over 25 percent in 2000 and more than 6 percent in 2001's first quarter, according to the CSFB/ Tremont Convertible Arbitrage index, Credit Suisse First Boston estimates that half of all convertible bond trades now come from hedge funds.

Top-performing fund managers utilize proprietary pricing strategies to identify "arbitrage" opportunities in a wide range of domestic and international markets, focusing on pricing relationships between convertible bonds, warrants, options and their underlying equity. Trading decisions are typically based on a comparison of the market value of the convertible security with a mathematically computed expected value relative to the price of the underlying security. Positions are hedged to the extent appropriate and feasible in order to produce a "delta-neutral" result. Trading strategies may be based on perceived volatility, interest rate differential or foreign exchange factors.

In addition to convertible arbitrage, other true convergence strategies include risk, or merger arbitrage, where two merging companies establish a relative price for their securities when the deal is announced. The fund manager, betting that the deal will close and the prices will converge, simultaneously buys the cheaper security and sells short the more expensive one, then waits for the merger.

Another example of true convergence is corporate structure arbitrage, where the fund simultaneously buys and sells different classes of a company's securities. The two stock classes represent different investor groups and may be mispriced in relation to one another.

Michael Dubes writes on investments from Coto de Gaza, Calif. He can be reached at [e-mail].