ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

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New Strategies in Alternative Investments

November 9, 2010

by Robert Huebscher

Absolute-return funds faced extensive redemptions, revealing another flaw in their implementation.  Advisors found that funds-of-funds did not have the same liquidity provisions as their constituent funds.   Funds-of-funds had offered more flexible redemption privileges than their underlying funds offered and, when redemption notices arrived, they were forced to put up “gates” to conserve cash and to reallocate investments to underlying funds that were more liquid.  Welch noted that liquidity issues were mostly limited to absolute-return funds and did not affect either long-short or commodity-trading advisors (CTAs).

The result was poor performance for absolute-return funds.  Their popularity was further tainted by the Madoff scandal – even though Madoff did not operate a hedge fund.

Net outflows from hedge funds began in 2008 and continued until about three months ago, Welch said.  The use of leverage has “dropped significantly” and many funds – which he called the “pretenders” because of their over-reliance on leverage – have gone away.  Talented hedge fund managers, Welch said, were “humbled” and have renegotiated fees and increased transparency.

They are now launching mutual funds, which, Welch said, has sparked renewed interest in alternative strategies, countering the aversion many advisors and investors have to the limited partnership structure.

I’ll return to the rise of these new exchange-traded vehicles, but first let’s look at the track record of common hedge fund strategies over the long term.

The long-term record for hedge funds

Welch provided data showing the 20-year performance record for several classes of hedge funds.

Below is a comparison of rolling three-year performance for the HFRI funds-of-funds index (which Welch said is an accurate proxy for absolute-return strategies in general) and bonds, represented by the Lehman/Barclays aggregate bond index:

The red-shaded areas indicate outperformance by funds-of-funds relative to bonds, and the grey areas indicate the reverse.   Over the 20 years ending in 2010, these data show that absolute-return outperformed in regimes of rising rates, Welch said, and provided the desired diversification to the equity component of a portfolio and the right complement to the bond portion.

This bodes well for the future, Welch said, since “rates have nowhere to go but up.”