Stress testing bank balance sheets is back in the news as regulators look for confirmation that recovering banks are strong enough to survive a double-dip recession.

Stress testing bank balance sheets is back in the news as regulators look for confirmation that recovering banks are strong enough to survive a double-dip recession. This month is also the anniversary of two notable stress tests for markets; it is twelve months since equity markets bottomed and ten years since Nasdaq reached its high point.

In 2000, as the technology sector imploded, there were concerns that the evaporation of paper wealth would cause a recession. In response, central banks lowered interest rates and ensured that there was ample liquidity to keep the wheels of industry turning. Investors also reacted by starting to move money away from equities, which had delivered exceptional returns since 1982, in favour of alternative, less correlated strategies such as hedge funds.

Hedge funds duly delivered on the performance side, producing a relative return between 2000 and 2003 of +30 per cent at a time when equities declined, peak to trough, by 40 per cent. Estimated hedge fund assets doubled to nearly $1trillion during this period.

The events of the last few years have tested all investment strategies almost to breaking point and it is, therefore, timely and instructive to see what did well and which promises were broken.

It is clear that, despite a constant stream of adverse publicity, hedge funds collectively de-correlated from equities in 2007-2010, just as they did in 2000 and 2003. The only difference this time is that the ride has been slightly bumpier and, as a result, investors no longer assume that hedge funds are a permanent diversifier within a balanced portfolio based on effortless superiority when compared to long only equity strategies. On balance, however, not a bad result by hedge funds during an extraordinarily difficult period. It is no surprise that both private clients and institutional investors are once again increasing exposure.

On closer inspection of the results achieved by hedge funds over the last three years, several factors become apparent. Up until the middle of 2008, hedge funds were making money despite the erosion of confidence in equities as economic growth deteriorated and the financial system started to shake. However, when doubts about the banking system caused a seizing up of financial markets and the extinction of several huge institutions, there was nowhere to hide, which is why hedge funds as a class lost nearly 16 per cent between September and November 2008 and declined for the year as a whole by 19 per cent. As soon as the banking system stabilised and liquidity returned to markets, the recovery started. On average, hedge funds produced a return of just over 20 per cent last year - a good result, although behind equities which were up by 30 per cent.

Many investors choose to gain exposure to hedge funds by using fund of hedge funds.  The advantages of fund of funds are:

- diversification

- manager selection and due diligence

- active management of the selected portfolio of hedge funds

A negative for fund of funds is the extra layer of cost and over the longer term, this has resulted in underperformance relative to single manager hedge funds. A couple of points at this stage:

(a) It is very difficult to determine how well hedge funds are performing as a group. Various indices are published and these are the best guide, but factors such as index construction (equal weighting or size dependent), survivor bias (bad funds cease trading and so drop out of the index) or that managers simply stop reporting, all introduce distortions.

(b) Not all hedge funds are open to new investors and so the theoretical average may be difficult to match in reality.

Comparing the performance of the hedge fund index to the fund of fund index over the last few years shows that, on balance, fund of funds delivered reasonable returns relative to the index of single managers in stable times, but then in 2008, the divergence started to increase. Not entirely surprising given what was going on, but disappointing nonetheless.

However, the real problem only became apparent in 2009 when fund of funds delivered +11.5 per cent, underperforming the composite hedge fund index by 8.5 per cent. What had gone wrong?

Fund of funds investing in hedge funds suffered from a liquidity mismatch during the latter part of 2008. Investors looking to raise cash, quite reasonably, withdrew money on agreed terms of notice but, at the same time, many hedge funds (the assets of the fund of funds) adjusted repayment terms or suspended redemptions. This left fund of funds with dissatisfied clients.

As markets normalised, this mismatch subsided and fund of funds put in place procedures to stop this happening again. They started to hold more cash, but more importantly shifted the investment focus in favour of more liquid, easily realisable hedge funds. In practice, this resulted in an increased focus on strategies such as Macro.

All would have been well, but unfortunately, as equity markets recovered, these strategies were the worst performers. Using HFR as a source of information, Macro funds produced an average return of -2 per cent in 2009.

The events of the last few years have eroded the case for fund of hedge funds. However, before classifying them as a model that failed the stress test, it is most important to understand that these funds are not a homogeneous benchmark driven sector. Differences between managers are significant and a number have delivered much better numbers than the average.

What is clear is that selection skills backed up by detailed research is just as important when choosing a fund of funds as in any other investment area. We focus on the following factors:

(a) Experience of the investment team.

(b) Funds under management - between $500million and $5billion is the sweet spot.

(c) A commitment to add value through manager selection and tactical strategy changes.

(d) Diversification of the investor base. Fund of funds that have attracted leveraged investors are likely to be vulnerable should there be a further sell-off. Diversification and due diligence remain the key attractions of fund of hedge funds. Nothing that has happened in the last few years changes this. Investors, however, need to be wary of taking on extra cost for no added value.

As the hedge fund industry has developed, there are more ways for private investors to gain exposure. Over the last twelve months, we have taken advantage of trading opportunities in listed hedge funds, which are part of the investment trust sector. At the start of 2009, most funds traded at substantial discounts to net asset value. Supported by good performance, discounts narrowed as confidence returned, helped by corporate activity including buybacks and continuation votes. On average the listed sector was up 40 per cent last year.

Of increasing interest are single manager fund of hedge funds. This is where a hedge fund manager creates a portfolio of its own range of funds covering a variety of different strategies. This gives investors access to a diversified portfolio yet with the core qualities of an individual manager. As a result there is greater control and transparency both of which are attractive features in this environment.

The growth of UCITS III funds is also creating opportunities for investors to diversify away from conventional fund of funds. The UCITS rules impose liquidity and leverage restrictions designed to protect investors from excessive risk. Only certain hedge fund strategies fit, but a number of fund managers have launched funds and many more are planned. At present $50billion assets are committed to UCITS III funds and investors have a choice of over 250 different funds. The advantage for investors is liquidity and a smaller minimum unit size. It is, therefore, possible to build a diversified portfolio of hedge fund managers and strategies whilst being reasonably confident that the portfolio can be adjusted or liquidated when required.

Traders on the Chicago Futures Exchange used to trade a strategy called the Yellow Toyota, having spotted a link between the Yen exchange rate and the price of corn. The hedge fund equivalent should be a combination of Ronseal and L’Oreal. Hedge funds and fund of hedge funds passed the stress test of the last three years and remain an important component of a diversified portfolio. As ever, active management based on careful manager selection is the key to successful implementation.

Funds that deliver good performance driven by a clear investment process are definitely worth it.