By Bill Hauser
It is important for investors to recognize the differences in the risk/return profile of hedged strategies versus long-only products. It’s not a matter of hedged strategies being more or less risky than traditional long products; the fact is that the risks are very different.
In long-only funds, an investor is primarily being exposed to the underlying attributes (risks and rewards) of the broad investment market (systematic risk) and sector selection. Meanwhile, individual stock selection has relatively limited impact on an investor’s return. Managers use diversification to protect against systematic risk. Some managers often employ a quasi-indexed approach—aggressive bets away from the benchmark are discouraged, since minimizing deviation from the benchmark (tracking error) is a primary goal.
In a hedged strategy, manager acumen takes center stage. It is the manager’s ability to exploit mispricings and isolate risks that generate profits. Appropriately conceived hedging strategies, more than diversification, are used to minimize systematic risk. Stock selection, both on the long and short side, receives great reward in a properly structured hedged portfolio.
However, the underlying benefits of real estate securities and impact of the overall market direction are diminished. Real estate stocks are simply the tools by which the manager delivers a targeted risk/return profile. (And under a hedged format there is greater opportunity to adjust the level of risk versus return than in a long-only portfolio.) On the other hand, the much-heralded virtues of investing in real estate securities fade away.
In fact, investors should avoid the misconception that they are achieving real estate or real estate securities exposure through investment in a real estate hedge fund. After all, most hedge fund managers are targeting low correlation to the overall market—or, in the case of real estate hedge funds, low correlation to real estate-specific indexes. With that said, there may be times when the market is more or less favorable for execution of a manager’s strategy. For example, hedge funds within the arena of distressed securities saw returns drop during the bull market of the late 1990s.
An additional consideration relates to the fact that, as too many managers seek to execute a particular strategy, market inefficiencies become more difficult to exploit. For example, look at merger and arbitrage funds that traditionally have been an area that delivered superior risk-adjusted returns. Over the years, non-dedicated investors (even retail investors) began to participate in merger and arbitrage trades, generally without sufficient regard for the risks that a deal might not go through. As a result, investment spreads have thinned, and some of the largest funds have re-aligned their strategies. For the moment, liquidity and opportunities within the real estate sector continue to grow in line with the number of entrants coming into the space. Moreover, there is clearly an opportunity for skilled managers to expand the investment universe—after all, adoption of the REIT concept has taken hold on a global basis.
There are a number of additional issues for consideration. For example, liquidity, investment minimums, fee structures, taxation and the use of leverage, to list a few. Hedge funds generally require minimum initial investment periods and only offer liquidity at defined points thereafter. Investment minimums and other criteria bar most retail investors from access. It is important to note that fund performance is separate from taxable gains and losses in any particular year. Hence, it is possible that a fund delivers negative performance but still generates taxable gains.
Hedged strategies are more dependent on the manager’s ability to execute than on the overall market—and even the best of managers will at some point misjudge. For better or worse, management ability matters more than direction of the market, so choose wisely. And while profits compound with the use of leverage, so can losses.
