How Family Offices View Hedge Funds

I interviewed Michael Oliver Weinberg who has served as a CIO at a NY single family office and has extensive experience in hedge fund investing and asset allocation. Given his background, I wanted to get his view on investing in hedge funds. Here’s an interesting excerpt from my interview with Michael:

Richard C. Wilson: You shared your view on investing in hedge funds at one of our Family Office conferences in New York. Do you mind summarizing those views here?

Michael Oliver Weinberg: Recently, there has been a great deal of press and family office sentiment against hedge fund investing. Family offices are less interested in hedge funds because they have underperformed the long-only indices for five years. Though this is not untrue for the indices, for starters we would not likely be inclined to invest in a hedge fund index or espousing anyone else to. One of the primary advantages of investing in hedge funds is the alpha at the manager level and the allocator level. Hedge fund indices are averages and inherently provide hedge fund beta without the alpha.

The next flaw with the viewpoint against investing in long-only versus hedge fund is the assumption that markets will go up. Though they have historically over time, they may not for very long periods. For example, the Nikkei peaked nearly 25 years ago and over that period is down roughly 60%. Another example is the S&P 500 which peaked in 2000 and did not reach that peak level again for 13 years. A buy and hold investor would have been roughly flat, other than the dividend yield, over that 13 year period.

In both of these markets over both of these time periods, we know and have been invested in top hedge funds that have earned substantial double-digit positive annual returns. Many families that are opposed to hedge funds also cite the high fees as a reason for opposition. We would pose the question to you or them, would you prefer higher fees and double-digit positive NET returns (so after fees) or passive, low-fee, long-only indices that are flat or down material amounts over long periods? We would prefer the higher fee, higher net return option. Never mind that hedge fund fees are currently under pressure and often at substantial discounts to the former 2 & 20 model.

Then the question is how hedge funds achieve these positive returns in bear, volatile, or flat markets. The answer is the short-side, risk management and the resultant downside protection and capital preservation. Sure, over a five-year bull market, long-only funds might outperform. However, at least based on history, they have dramatically underperformed over cycles, including bear markets.

For example, if one looks at the S&P 500 total return index in 2008, it was down 37%. This compares to the Credit Suisse Broad Hedge Fund Index, which was only down 19%, roughly half as much. The way the ‘101’ compounding works is that an investor would need a roughly 60% return to break even in the S&P versus only a 25% return to break even in the CSBHFI. In addition, the hedge fund managers who are down do not collect incentive fees until they return to the high-water mark.

Similarly, when we worked at one of the top macro-funds, one of the primary risk rules was to take most if not all exposure off when down 20%, because a 25% recovery was viable in not too long a period. However, returning to break-even when down substantially more than that, such as twice as much, is much more difficult and time consuming.

Lastly, to incorporate a modicum of modern portfolio theory, if a strategy offers the same returns with less risk or higher returns with the same risk, that is akin to the proverbial ‘free lunch’ and should be incorporated into an optimal portfolio. Top hedge funds do exactly this, and for this reason should be incorporated into traditional portfolios. In fact, we would even go as far as to espouse minimal traditional exposure and maximum hedge fund exposure due to the aforementioned reasons.

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