“One of the great things about hedge funds is that they have provided a field day for academic researchers to write scholarly articles on their risks and returns. Yet, for all of this scholarship, a practical roadmap to hedge funds has remained elusive. Until now.”

So begins a new 168 page treatise aimed at dispelling the “myths” surrounding hedge funds and educating investors.  The document, called “Road Map to Hedge Funds” was released this morning by the Alternative Investment Management Association (AIMA) and is squarely aimed at an institutional audience (the report is also bylined by The CAIA Association, UBS, and CalPERS).  Co-authors Alexander Ineichen of UBS (see related posts & interview) and Kurt Silberstein of CalPERS cover just about every question an institution might have about this poorly understood category of investments.  In his foreword to the document, alternative investment pioneer Mark Anson describes it as a:

“…pragmatic, user-friendly book that will go a long way to breaking down the myths of hedge funds while providing the user the ability to construct an intelligent hedge fund portfolio. Along the way, the psychobabble of the hedge fund world is eschewed to provide a commonsense guide in commonsense language that all can understand.”

Regular AllAboutAlpha.com readers will recognize a lot of the thought leaders quoted in the “book”: Larry Summers and Sandy Grossman from the recent “unnamed event” in Boston (see related posts), Peter Bernstein author of Capital Ideas Evolving (see AAA review), Nassim Taleb (see related posts), Lars Jaeger (see related posts), Andrew Lo (see related posts), Larry Siegel (see related post), and of course, Ineichen himself, who is also the author of Asymmetric Returns.

But beyond the usual alternative investment crowd, the document makes liberal reference to names more commonly associated with “traditional” thinking: Benjamin Graham, Winston Churchill, Mark Twain, Albert Einstein and Warren Buffett (yes, even the man who says hedge funds can’t even beat the S&P 500 over the next 10 years – see related post).

If you are really into the topics covered on this website, you may find the document to be a little basic (it’s designed for an “intermediate” audience).  After all, we eat Anson’s “psychobabble” for breakfast.  But the document does a great job of bringing together all of the salient topics in one easy-to-read form.

It’s not all hedge fund cheer leading either.  For example, page 14 makes reference to the fact that hedge fund returns have been lower this decade than they were in the 80’s and 90’s and page 16 shows how wildly disparate industry size estimates have become.

But the most interesting part of the document is its myth-busting.  For example, for those out there who think hedge funds are taking over the world, check out this chart from the report…

See the two tiny bars on the right?  The entire hedge fund industry is smaller than the assets under management of a single firm (likely UBS we’re guessing).  This, despite what some have described as tsunami of institutional assets flowing into hedge funds over recent years.   According to data cited in the report (below), the tsunami wouldn’t even show up on the chart above.

As relatively active investors, hedge funds may indeed have a disproportionate influence in smaller, less liquid corners of the capital markets.  But this report clearly dispels the notion that they dominate capital markets in general.

Other myths addressed in the report include:

“Myth: Hedge funds gamble”

“…We do not think that there is an award for the most hilarious remark about hedge funds. If there were such an award, a strong contender for first prize would be the institutional investor who was quoted saying: “No, we don’t [currently invest in hedge funds]! It is completely obvious that hedge funds don’t work. We are not a casino.” The irony, of course, is that it is the long-only investor who depends most on luck and not the diversified hedge fund investor…”

“Myth: Hedge funds always hedge”

“…Returns are a function of taking risk. Hedge funds do not hedge all risk. If all risks were
hedged, there would be no return. The difference between hedge funds and long-only
managers is that hedge funds hedge certain risk while consciously being exposed to risk where
they expect a reward from bearing the risk…”

“Myth: Hedge funds are risky”

“Hedge funds, examined in isolation, are risky…To most investors, it is regarded as unwise not to diversify idiosyncratic risk. It should be similarly unwise not to diversify risk to a single hedge fund. Note that many critics of hedge funds do not distinguish between systematic and nonsystematic risk when demonising hedge funds…”

“Myth: Hedge funds are speculative”

“The misunderstanding of hedge funds being speculative comes from the myopic conclusion that an investor using speculative instruments must automatically be running speculative portfolios.”

“Myth: Hedge funds charge high fees”

“The attractive incentives in the hedge fund industry are regarded as one of the main drivers of high returns of hedge funds since it attracts managers who have – or are supposed to have – superior investment skill…

“…a higher proportion of the hedge fund manager’s capital is invested in positions about which the manager holds conviction (so) the management fee paid by the investor is based on a portfolio that consists of positions that are 100% managed actively.”

“Myth: Hedge fund generate strong returns in all market conditions”

“…hedge fund strategies are sometimes correlated with equities in a down market and sometimes not. If hedge funds are correlated with the stock market on the way up, that is actually fine with most people…”

“Myth: the lesson of LTCM is not to invest in hedge funds”

A picture says a thousand words…

And the list of myths goes on…

“Myth: hedge funds increase systemic risk of financial markets”

“Myth: selling short is the opposite of going long”

“Myth: there is no absolute return revolution”

The section on hedge fund myths ends with the following observation:

“There is still a lot of mythology with respect to hedge funds. Much of it is built on anecdotal evidence, oversimplification, myopia or simply a misrepresentation of facts. Although hedge funds are often branded as a separate asset class, a point can be made that hedge fund managers are simply asset managers utilising other strategies than those used by relative return long-only managers. The major difference between the two is the definition of their return objective; hedge funds aim for absolute returns by balancing investment opportunities and risk of financial loss. Long-only managers, by contrast, define their return objective in relative terms. They aim to win what Charles Ellis calls the loser’s game – that is, to beat the market.”

Despite the media sensationalism surrounding hedge funds, this is probably a good example of the “common sense” to which Mark Anson refers in his foreword.  So we highly recommend that you download the document (here), load up your printer with 200 sheets of fresh paper, hit print and grab a coffee.  At the very least, you’ll have something to read on the commute home this week.  Just don’t read it while you’re driving.