Every time a bell rings....
Should you cut your hedge exposure?
MBMG IA’s Paul Gambles recently participated as an expert panellist at the Hubbis Digital Dialogue Series event on Hedge Funds and their Role in Private Client Portfolios Today, highlighting the diverse potential within the hedge fund universe, emphasizing that with the right approach, hedge funds can cater to a wide range of investor needs.
(Please note that the transcript has been edited to provide greater clarity and enhanced reader engagement)
“While many wealth managers aim to maximise returns by preferring newer managers, our bias at MBMG IA is aligned with our clients’ expectations that we focus on managers with more of a capital preservation profile rather than a maximum potential return profile. Despite this, we have successfully advised investments historically into some newer, smaller managers.”
Paul cited the example of the now well-established hedge fund, Kerrisdale Capital, which had continually. cropped up on MBMG IA’s statistical and qualitative analysis market analyses in the years following the GFC. It actually took a deeper dive, including a visit to their New York base, to really achieve a satisfactory level of comfort with the firm, its people and its approach. Kerrisdale’s use of credit analysis to generate many of their extremely successful short ideas provided them with a distinct investing edge that they were able to demonstrably exploit as a source of alpha (i.e. generating additional returns without a compensating increase in the level of risk). Since then, Kerrisdale has gone on to become a significant success story, perhaps best known for its activism and campaigns, but the building block of our level of comfort was their use of a capability that they could demonstrate generated additional risk-adjusted return, grafted onto the very well-established approach of long-short investing. While Kerrisdale hasn't become one of our primary allocations, it has been an extremely worthwhile exposure.
But the majority of our advice tends to focus on established managers, with whom we've had relationships for many years, if not decades. Paul noted that this still requires ongoing, due diligence. The successful performance of managers or funds for us and for our clients over many years doesn't remove the obligation to monitor not only ongoing performance, but also consistency of approach, adaptability to changing demands and continued discipline, to ensure that they remain compatible with what we and our client portfolios require and expect from them.
Paul cited the example of the transition from SAC to become Point.72.
Paul also discussed the complexities of hedge fund analysis, highlighting the importance of understanding each fund's strategy across market cycles. Reflecting on past advisories, he underscored the unique risks in specialized markets, cautioning against ventures into obscure sectors without comprehensive risk evaluation.
“This was a major event for them, which made it necessary for us to ensure that post-transition, they would continue to operate in a way consistent with their history and heritage and DNA. In general, the Modus operandi of hedge funds makes it difficult to access all the information or to understand what's going on under the hedge fund bonnet. One of the key factors that we apply is estimating the degree of probability that a fund can deliver expectations. In order to achieve this, it's important to understand which strategies work best in which parts of the cycle and which ones aim to work throughout the cycle, while also applying these criteria to the managers. A few years ago, we were asked to author a paper on a group of French hedge funds that had failed. The French hedge fund market had a number of unique or at least defining characteristics that made it different to the German or the UK or the American markets, especially specialisations in arbitraging obscure parts of the credit market to generate outperformance of mainstream credit markets. Unfortunately, when you find yourself in dark corners of the credit markets, which increases the risk that you're going to get tripped up. Which is precisely. what we had warned would happen and precisely what did happen to a couple of high-profile hedge fund boutiques. The key point is to know and to understand your markets and to know what to expect and what to look for. Paul then explained why hedge funds’ stated preference for relationships with independent advisors like MBMG Investment Advisory and our High net worth and family office clients-
“A number of hedge funds have indicated that they have more sustainable relationships with advisors and with their clients than with distributors such as private banks, largely because the private bank model in some cases remains significantly transactional (banks themselves make most money when assets are bought or sold; therefore, for hedge funds seeking long term relationships, this is potentially a mismatch). Also, this transactional product distribution approach can lead a focus on ‘flavour of the month’ investing, rather than sustainable, consistent, allocation.
Finally, Paul addressed the idea that investing in hedge funds can be risky. Having again, reiterated the need for understanding and for due diligence, he pointed to his own experience that it has been easier to make mistakes investing in traditional, directional capital market assets such as long only equities, than in the hedge fund space, recalling a comment he made to Bloomberg’s Tracy Alloway that ‘long-short, investing means never having to say you're sorry’. Paul added that “probably the biggest hedge fund we mistake that we've made over the years is not having had an even greater exposure to hedge funds.”
Paul explained his preference for hedge funds that work across the cycle, removing the execution risk associated with having to try to time cycles with specific strategies. Paul was asked whether underperformance relative to beta during booming markets should be considered as part of the cost of investing in hedge funds or whether they should take additional risk at certain times in order to try to keep up with the market. Paul explained the difficulty of trying to disentangle Alpha (value added by the manager) from Beta (the value derived from the market) during upside markets-
“Performance alone is often a poor indicator of this until things go wrong when it’s too late. If variability in risk exposure is an inherent feature of the manager approach and this is defined and measurable, that can be an added source of Alpha but in general hedge fund selection should be significantly based on clear risk criteria and discipline and adherence to fund objectives and fund criteria. Any fund that departs from stated criteria in ways that isn’t part of their process and isn’t immediately evident should be viewed with suspicion by allocators, because of the difficulty, if not impossibility, of calibrating the role of such a variable risk factor within a portfolio.”
He illustrated this with comparative performance charts:
Chart One shows the performance of the Dow Jones Industrials since 2000:
It can be seen that there are setbacks but investors who have remained invested for 23 years have achieved returns of over 330%.
Chart Two compares the performance of the Dow to the performance of Warren Buffett’s Berkshire Hathaway. While Berkshire looks more volatile (to some people’s surprise), it also puts the performance of the Dow very much in the shade, having generated returns of 720% over the same period:
The final chart adds in an equal weighted exposure to two of MBMG IA’s advised exposures – Point72 and Millennium:
The reduction in visibly evident volatility of hedge funds compared to Berkshire Hathaway and the increase in return is immediately obvious.
And yet a significant consensus of investors likely still clings to the belief that Berkshire Hathaway offers higher returns at lower risk than the hedge funds.
MBMG Investment Advisory is licensed by the Securities and Exchange Commission of Thailand as an Investment Advisor under licence number Dor 06-0055-21.
For more information and to speak with our advisors, please contact us at info@mbmg-investment.com or call on +66 2 665 2534.
About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
Disclaimers:
1. While every effort has been made to ensure that the information contained herein is correct, MBMG Investment Advisory cannot be held responsible for any errors that may occur. The views of the contributors may not necessarily reflect the house view of MBMG Investment Advisory. Views and opinions expressed herein may change with market conditions and should not be used in isolation.
2. Please ensure you understand the nature of the products, return conditions and risks before making any investment decision.
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