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The hedge fund industry has a notoriously muddied reputation. Since the 2008 global financial crisis (GFC), many investors have been averse to the prospect of risky investments, and the lucrative nature of hedge funds has taken much criticism.

On December 8, William J. Kelly, CEO of CAIA Association, presented his thoughts on the changing investment landscape during a luncheon at Tokyo American Club. He explained the value proposition of alternative investments, looked to clear miscommunication in media, and clarified misconceptions about the industry.

In the current economic landscape, which hosts negative interest rates, how does the regular investor guarantee—with only a limited chance of loss—a reasonable return?

“We’ve got an overheated 60–40 investment model, and a lot of people have forgotten the value proposition of alternatives,” Kelly began. The investment model, which consists of 60 percent assets in equities and 40 percent fixed income, is described by Kelly as a “riskier place to be.”

The idea of fixed incomes guaranteeing a rate of return is an asset allocation that does not allow for the ebb and flow of a volatile marketplace. This traditional model is one that Kelly believes no longer works in the current market.

Referencing Howard Marks’ book The Most Important Thing, he explained: “When other investors are unworried, we should be cautious. When investors are panicked, we should turn aggressive.”

This is where the value of alternative investments comes into play. “The biggest risk an investor faces is drawn-down risk, and if I look at the value of alternatives—if they are sold right—it can soften down some of those edges,” he said.

To emphasize the advantages of alternative investments—and specifically hedge funds—Kelly focused on the pension crisis that swept the United States following the crash of 2008. Pension funds had been considered relatively low-risk, but this all changed when there was insufficient return on the money companies and the government had reserved for pensions.

“Fewer workers for retirees—it’s a horrible value proposition,” Kelly stated, addressing the aging of society that is consistent throughout the countries that are members of the Organisation for Economic Cooperation and Development. Kelly said that governments are continuing to head toward a point at which they won’t be able to fund pensions. Perhaps the answer lies in hedge funds.

However, this “comes full circle,” he explained, to some of the challenges that practitioners have in the alternative space—particularly hedge funds.

With this massive funding deficit, Kelly said, “they’re saying ‘I’ve got to find this return somewhere,’ let’s turn to hedge funds. And when the hedge funds perform like they were supposed to perform, they are very disappointed because they are thinking ‘these high-octane vehicles need to give me 12 to 14 percent.’ This is simply not reality.”

This is where the widening dispersion of performance return comes into play. The rate of return is dependent on the hedge fund, and the dispersion of return has greatly increased with more alternative investment options.

There is currently monetary intervention across the globe, he explained, with “massive balance sheets being created by central banks,” and the money from an investor’s standpoint is “flooding in to the equity markets, so you have massive price appreciation; and this is not sustainable.”

Before the GFC, you could get the offsetting benefit of low correlation between asset classes, but now this is “much less true,” Kelly said. The correlation of equities with other assets has gone up, so there is a benefit there; but “not nearly what you had before the GFC, which underscores all the more reason you’ve got to think about alternative sources of return.”

ACCJ Alternative Investment Subcommittee Co-Chair Frank Packard presents a certificate of appreciation to William J. Kelly.

Looking at the media coverage that hedge funds have received, Kelly explained that this negative and misunderstood exposure is creating a problem with public perception: “We’ve got to take a stand. If we don’t, the press is going to keep hammering, and the value and concept of alternative investment is not going to be understood.”

Ultimately, the public sector has put money in hedge funds to try to achieve a higher rate of return, with the idea that increased risk will lead to increased reward. But hedge funds have not been able to support this. He highlighted unrealistic expectations as being a continuous problem that is not helped by media coverage.

One of the misconceptions of alternatives, he explained, is they “are high-octane, high-return vehicles that really make high returns.” But, he added, “if you buy alternative [correctly], it’s meant to dampen down the volatility; and I think some of the criticism for alternatives has been— just after the GFC and more recently—they were yielding 3 percent on average, and investors are very disappointed with that.”

He told the audience that a portfolio should include inexpensive funds that track the market rate of return, and remaining allocations should be put in alternative investments portfolios that can outperform the market.

Each hedge fund has a very different risk profile, and under certain circumstances you are not appropriately rewarded for your risk exposure. Because of this, it is vital that you do proper due diligence.

“When the press writes a headline [such as] ‘the average hedge fund returns are not very good,’ they are right—the average is not very good. But the dispersion of returns from the top to the bottom is massive,” he explained. “To throw the entire asset class out makes very little sense.”
He said that there is still a tremendous amount of cash not currently in the market. “A lot of investors are sitting on the side saying ‘I don’t know what to do.’ This is basically mattress money, and if it stays in the mattress, inflation—at no matter what level you are—is going to kill it.”

He concluded that it is crucial to be “clear about your investment process and try to understand the allocator’s return expectations.” It is here where people-talent, clear communication within the investment space, sound ethical standards, and setting minimum standards of professionalism in this industry are imperative.

Maxine Cheyney is a staff writer for The Journal.
One of the main issues is that people have cash, but no one is willing to invest.