Everybody agrees that hedge
fund investing has to change. For JANA asset consultant MICHAEL O’DEA, these dislocated
markets are perfect for investment in hedge funds, but he recommends keeping
control through a managed account platform. The situation After the events of 2008, investors around the
world have begun to seriously question the merits of investing in hedge funds,
which is not surprising when so many failed to deliver positive returns and
offered questionable diversification benefits to portfolios when most needed.

is also quite easy to criticise an industry that for years has been ostensibly self
serving, by charging high fees, and paying themselves performance bonuses many multiples
of the high CEO salaries of some of the largest companies in the world. The
industry as a whole has also been periodically marred by individual high
profile blow-ups and frauds (LTCM,
Beacon Hill,
Amaranth, Bernie Madoff, the list goes on).

In an attempt to differentiate themselves
some hedge fund-of-funds claimed to offer access to “investment legends” and
marketed their ability to secure capacity in tightly held funds. These claims
fuelled a bubble in allocations to some poorly structured hedge funds, while
some investors did not have a full understanding of the true risks and
liquidity profiles of these investments.

These risks have been made apparent
through the recent market environment. Although, in aggregate, hedge funds
outperformed traditional 70/30 growth/defensive balanced funds in 2008, hedge
funds suffered the worst period of returns ever, understandably disappointing
many investors. When one dissects the reasons for this performance it is
explainable and even understandable. However, it is another issue to have poor
performance complicated by operational problems caused by the structural
deficiencies of fund-of-fund and individual hedge fund investment vehicles.

2008, largely due to the lack of liquidity, many hedge funds encountered problems.
The reasons were varied and disappointing; some suspended redemptions, some
closed out foreign currency hedges, others had assets held with Lehman Brothers
when it filed for bankruptcy, and more recently the announcement of potentially
one of the biggest Wall Street frauds – Madoff ’s alleged US$50 billion Ponzi
scheme. Are Hedge Fun ds Dead? While the description so far paints a bleak
picture for hedge funds, we are not suggesting investors wash their hands of

There are many important lessons to be learned from recent events which,
if applied, actually serve to strengthen the case for hedge funds, particularly
in today’s environment. The events from the past 12 months have clearly
identified where things have got to change but the issues outlined above are
surmountable and, in our opinion, hedge funds are worth the time and the effort
to get right. We believe that the return potential of hedge funds remains

Much of the “herd” behaviour of investment markets and the impact of
government regulations and constraints create massive inefficiencies which
unconstrained investors (hedge funds and some long term investors) can and do exploit.
Opportunities abound across asset classes and between securities and sectors
within asset classes, and even more so in non-traditional investments like
convertible bonds which have been savagely sold off beyond any conservative calculation
of fair value.

Although there is less leverage available to hedge funds there
are two things in their favour: First, the opportunities are so great that less
leverage (if any) is needed to generate very attractive risk adjusted returns;
and second, there are far fewer hedge funds and much less competition in the
hedge fund space from investment banks, which should make capturing these
inefficiencies much easier for those who have survived. With little
transparency into future corporate earnings and the end of the credit crisis
difficult to predict, now is not the time to be reducing a portfolio’s diversification.

Hedge fund strategies offer diversification benefits to a portfolio through
their low volatility and long term low correlations to existing strategies. Our
experience has shown that what have been classified as hedge fund techniques
can lessen a balanced fund portfolio’s dependence on one economic scenario –
the “perfect world” of improving global growth and stable inflation rates which
fuel equity markets. If a less than perfect scenario unfolds, like slowing
growth or rising inflation, there is a very real chance that most traditional balanced
funds will not achieve performance objectives.

Few would contest that moving
away from this dependence would be of great benefit to investors by dampening
an investment portfolio’s losses in times of recession . Where To From Here for Investors ? We believe 2009 will be characterised by slowly
returning investor confidence in the financial system which will manifest
itself in a return of focus on fundamentals. In this environment, active
management should thrive and we feel strongly that this is a time when hedge
funds will redeem themselves.

But now, as always, we must be judicious in the
way we invest. Going forward, investors should be building portfolios which
capture some of the advantages of using leverage, short selling and
derivatives, but this needs to be executed in a very prudent manner.
Derivatives have a very tangible economic value, transferring risk from one
party to another. They can be very positive investment tools or very destructive
in the wrong hands. For JANA, adhering to some simple principles that are
particularly pertinent for investing in hedge funds can mitigate a number of

1. Maintain as much control over your assets as is reasonable. If you do
not have control over your assets there should be very high operational due diligence
hurdles. 2. Separate asset ownership from the portfolio managers’ control
wherever possible to limit the risk of fraud. 3. Demand position level
transparency from an independent source and employ appropriate third party risk
management systems. Do not rely on the manager to provide this data.

4. Ensure
the liquidity being offered is the liquidity of the underlying instruments. Don’t
invest in vehicles that run a liquidity mismatch between underlying manager
vehicles and their obligations to counterparties (e.g. FX hedging
counterparties) or investors. 5. Avoid managers/strategies that employ too much
leverage. These have blown up in the past and are likely to blow up again in
the future. 6. Invest in exchange traded instruments wherever possible as this mitigates
counterparty risk.

7. Pay fees that are reasonable, appropriate and
commensurate with the managers’ skill and re-investment into research. 8. Align
the risks of the investment with the remuneration of the manager. There is
little sense in paying away 20 per cent of the upside but assuming all of the
downside as the investor. All of the above principles can be achieved via an
investment in a managed account platform.

A managed account platform is one
where the investor, rather than the manager, has the fiduciary control over the
underlying investment positions created by the investment manager. This is identical
to the use of a custodian account for most investors with traditional mandates.
We believe managed account platforms will play an increasingly integral part of
the solution for investors wanting to benefit from hedge fund investing, but
have concerns over the key issues of transparency, control and fees.

After ten
years of virtually a zero return from global equity markets, the investment
community is gradually adapting to the shortcomings of the conventional
approach of investing but are disappointed with their recent experiences of
hedge funds. Resolving the structural flaws of hedge funds will be one
important step forward in the chase for higher, more stable returns, and
managed account platforms have an important role to play in achieving this outcome.



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