5 May 2007

Are Hedge Funds an asset class?

It has become accepted wisdom that Hedge Funds should be regarded as a separate asset class. They should have their place in a well-diversified portfolio next to the traditional asset classes of equities, bonds, property and cash.
While we certainly would agree that hedge funds have to be analysed and managed with special care we would like to disagree with the consensus.
What is being overlooked is the fact that the traditional assets are investment vehicles that (one hopes at least) produce a return over time that is not just the product of clever market timing. Equities pay Dividends, Bonds and Cash Deposits pay interest, Property gives a return in the form of rental payments.
When we look at the holdings of the average Hedge Fund we know that they contain elements of these asset classes. But one of the key elements of any hedge fund worth its salt is the fact that the fund might at any time be short any of these assets. It is basically a bet on the market movement. The bet is against other market participants with a different view and the net result is a zero sum game for the totality of those investors that hold these betting positions at any time.
It is certainly an exciting as well as a rewarding game to find those managers that are on the winning side. As in any human activity, there are always individuals that are better than their competitors at what they are doing. We only have to look at the Arts or Sport.
Timing of markets and asset classes is nothing new. Any investor who has all his money in cash for example, is 'short' the other asset classes. Hedge Funds are a new name for a more widespread use of market timing that also uses techniques such as derivatives, short selling etc more extensively. Very few Hedge Funds are really true to their name, i.e. hedging long and short positions all the time. Most have net long or short positions at most times. The new 'asset class' therefore can be anything to anybody at any time.
The main problem is, that - in contrast to the traditional asset classes - Hedge Funds to not introduce or rely on a basic inherent return (Dividend, Interest, Rent). The larger the number of funds, the more the investment returns (minus fees) generated by Hedge Funds overall will converge around a (possibly disappointing) average return.