Hedge funds bogged down by misconceptions? - 03/12/01

I am writing this letter in response to your article "There's danger lurking in the hedge funds" (Investment News, Jan. 15).1 felt a need to point out an implied fallacy that a majority of the press seems to be portraying.

The erroneous belief that hedge funds per se are "dangerous" or "risky" is one that is fueled by misconceptions and a lack of misunderstanding in the area.

For instance, the meaning of "hedge" insinuates reducing risk.

Most of the misconceptions are due to several factors such as a lack of regulatory oversight, a lack of transparency, the inability to advertise and even negative press reports.

Thus, it is important to understand the very nature of these investment vehicles, as well as the industry itself and how they relate to the traditional markets before broadly categorizing any risk profile.

More specifically, I would like to address some of the key points mentioned in your article.

The belief that most hedge funds are very concentrated in terms of holdings tends to be a misleading one.

In fact, most hedge fiends do not hold highly concentrated positions and typically have position size limits.

Additionally the rise of leverage is usually incorporated in extremely low-risk situations that can benefit from low-cost funding.

As a general rule, it is also important to understand that, with leverage, there often coincides a form of liquidity.

'This was not the case, however, in the Long Term Capital Management debacle.

Finally, not mentioned in the article is the idea of ?shorting." or "hedging out risk," to protect front any market declines.

The idea of shorting is the very meaning of a hedge fund. Unlike traditional investments, hedge funds differ in the range of allowable investment approaches, the goals of the strategies that they use, and in the breadth of tools and techniques available to the manager.

Implicit in these points is the large amount of variety and heterogeneity in hedge funds and the many different risk/return profiles associated with each.

Thus, it would he unfair to categorize all hedge funds in one group incorporating a high level of leverage and concentration.

According to a research paper conducted by Morgan Stanley Dean Witter & Co., dated November 2000, ?Hedge funds have produced risk-adjusted returns and alpha that are superior to traditional investments."

While incorporating several databases in the period between January and June 2000, MSDW concluded that all hedge funds as a composite had an annualized return of 18.9%, while the Standard & Poor's 500 stock Index returned 17.2%.

Annualized volatility for hedge funds was less than half of traditional markets, with a 5.5 % standard deviation and 13.7% for the S&P 500.

The Sharpe Ratio, a measure of an investment return above a risk free rate divided by its volatility, was exceptionally better for hedge funds, with a 2.5 compared with a lower 0.9 for the S&P 500.

All in all, hedge funds have had much scrutiny in the past few years but have proven to consistently outperform traditional markets on a risk-adjusted basis.

They have recently sparked the curiosity of investors, and with that curiosity is a need to better understand the industry and the strategies within.

A portfolio of hedge funds, or "fund of funds," can offer the most attractive risk-adjusted rates of return, with low to zero correlation to most traditional portfolios and, yes, far less volatility.

As your readers will increasingly clamor for hedge funds in their client portfolios, l would like to call your attention to LJH's role as a thought leader in the industry. I hope you will draw on our databases and white papers as an educational resource for your future commentary.          _x000D_