In our second quarter issue (before Summer 98), we noted that ‚market neutral strategies are not riskless, investors should not underestimate inherent strategy and structural risks when making investment decisions. We further noted that, managers are (being) forced to increase leverage, take directional bets or employ new strategies to generate returns in line with their track records. Now the third quarter has come and gone, the image of the hedge fund industry particularly those engaged in ‚market neutral‘ strategies have taken a beating and investors are jumping off the, market neutral bandwagon of last year and earlier this year and flocking to managed futures (CTAs), short sellers and any other strategy which performed well in August. Does this make sense? Depends.     

It is illustrative to first look at one of this year‘s favorite investment strategy, ‘leveraged market neutral portfolios’. It was strongly argued that investors should invest in a portfolio of uncorrelated market neutral strategies and leverage this portfolio to obtain a meaningful return. It should have been clear from the start that this is a dangerous approach as it reinforces structural risks found in the underlying portfolio and eventually relies solely on the low volatility of these strategies as opposed to taking a wholistic view of risk. While these strategies may be statistically uncorrelated, they are exposed to the same important risk factors: to name a few, liquidity risk (particularly in down markets), valuation risk and credit risk. The idea behind a well structured hedge fund portfolio of hedge funds must be to minimize risk in all its forms, not only volatility.     

Adding managed futures for example to a portfolio does help from several perspectives:   They have low exposure to those risks to which arbitrage managers are precisely exposed: they trade in liquid markets; tend to be transparent, trade primarily in the exchange traded securities thereby minimizing credit risk; are not subjected to valuation problems; and the investment managers tend to be regulated.      

Their investment strategies correlate lowly with other hedge fund strategies, not only statistically but conceptually.      

There are naturally limitations to include:       

— capacity constraints of some managers trading widely diversified portfolios      

— low Sharpe ratios      

— expensive fee structures often compounded by inflated brokerage costs.      

Ultimately, adding managed futures because of August‘s results is nonsense. Adding them because one understands the strategies, the associated risks and their interaction with the other hedge fund strategies makes perfect sense. Investors need then only to conduct extensive due diligence processes including often neglected legal aspects and not base their investment decisions solely on name recognition and historical performance.





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