What's so special about hedge funds?

The recent proclamation of hedge fund standards by the Hedge Fund Standards Board (HFSB, see http://www.hfsb.org/), an organisation sponsored by a group of 14 large London-based hedge fund managers, made me think about the question again: what is so special about hedge funds?

These Hedge Fund Standards cover three broad areas: a) disclosure of information (investment policy and risks, commercial policy, incl. fees and expenses, and performance to investors and counterparties), b) valuation, and c) risk management. While one could argue about the quality of these standards - and I will do so in a separate post - , perhaps the most important question to which these standards give rise is: why in the world are these standards specific to hedge funds? There is nothing in these standards that cannot or should not be applied to any investment portfolio. What is so special about hedge funds?

From a purely investment-technical perspective, the answer is of course "nothing". Indeed, the standards don't even define the term "hedge fund". I can only interpret this as an implicit admission by the authors that it is impossible to unambiguously define a hedge fund. The difference between "hedge funds" and "traditional" investment portfolios is equivalent to the difference between shades of grey. While "hedge funds" may have differentiated themselves in their early days from "traditional" portfolios in terms of the use of leverage, derivatives, short positions, and illiquid instruments, these days all of those techniques are used by so-called "traditional" portfolios as well. And while investor protection laws used to limit these strategies to professional investors, regulatory liberalisation, such as UCITS III, have made these strategies available to retail investors as well.

But hedge funds deliver absolute returns, rather than returns relative to some benchmark, you might argue. Wrong again. Not only are there many hedge funds that fail to maintain market-neutrality by taking market-directional bets, but the whole concept of an "absolute return" is nothing but a thinly veiled attempt to lure investors by trying to make them believe that it is possible to earn above-normal positive returns without downside risk. There is no free lunch. Just as "traditional" funds aim to outperform a particular benchmark but risk underperforming that benchmark, so "hedge funds" aim to deliver a target return above the risk-free rate at the risk of delivering a return below the risk-free rate. In that sense, a market-neutral hedge fund is a traditional portfolio that is managed relative to the risk-free rate at the risk of underperforming that risk-free rate. Conceptually, a hedge fund is nothing but a "traditional" fund with the addition of a short position in the underlying benchmark and the proceeds invested in cash. Of course, the underlying benchmark may be more risky than cash, but presumably it also has a higher return.

So if hedge funds and traditional funds are different shades of grey in terms of investment objective and strategies, then perhaps the only difference that remains in that hedge funds not only earn 1-2% of assets in management fees, but also charge around 20% of the upside. The only way to get away with charging such significantly higher fees, is, of course, to differentiate your fund from those other funds. Lacking any significant differences other than the fees charged, what better way to differentiate than to use the power of language and invent "hedge funds" as something different from "traditional" funds.

Once again, the HFSB standards in and of themselves provide a valuable set of principles to which all investment managers should be held. But rather than adopting one set of standards for "traditional" managers and another for "hedge fund" managers, let's integrate these standards with the standards of organisations such as the long-standing CFA Institute (http://www.cfainstitute.org/) so that we can compare all managers on a level playing field. And if we can abolish the term "hedge fund", one of the most misleading terms in the investment industry, at the same time, all the better.