The case for having multi-strategy hedge funds in your portfolio.
The past decade has been challenging for hedge funds. With the help of central bank easing, (publicly) listed equities have been the top performer; whereas hedge funds, as an asset class, have not been able to match, let alone outperform equities.
It was a reversal from the 1990s and 2000s when hedge funds had generally outperformed both equities and bonds. Adding in the complications that comes with measuring performance (given many hedge funds are unconstrained by nature), the dispersion of that performance, and fees, it is not surprising that many investors today are significantly under-invested in hedge funds.
So why are we talking about hedge funds right now?
In our view, there are at least three highly relevant reasons to talk about hedge funds now.
First, in expensive markets, diversification becomes more important.
In a trending market, diversification can sometimes feel unnecessary, but there is no knowing when a trend will reverse.
With both bonds and equities looking expensive across most valuation measures, it is prudent to add diversification to a portfolio. When markets turn, having this diversification will help to limit drawdowns, which is key to achieving superior returns in the long run.
Hedge funds, if correctly positioned, can add an important element of diversification to a portfolio.
While they are often thought of as having lower correlation with traditional listed equity or fixed income assets, in truth, not every hedge fund will automatically have that attribute. Given their unconstrained nature, having a low beta will depend on the strategy as well as the manager, which is why manager selection tends to be the single biggest risk. That is also a reason why the dispersion of performance within this asset class is large.
For investors who do not want too much single manager risk, we believe multi-strategy, multi-manager hedge funds are a good starting point. This helps to reduce single manager risk. And by their nature, multi-strategy hedge funds can more easily lower their beta. In fact many multi-strategy hedge funds are designed with this diversification as their primary objective.
Second, macro volatilities are rising, so taking on more market risk doesn’t always work.
The macro environment may turn supportive for actively managed unconstrained strategies. Apart from having to start from a position of high valuations, rising inflation concerns and interest rate volatilities have also impacted markets this year, eating into investor returns. And these problems are unlikely to go away any time soon. While the need to chase returns is understandable, adding more market risk is not a solution – as this just pushes investors out along the risk spectrum without increasing risk-adjusted return.
In this environment, alternatives, particularly those that can provide a less correlated source of alpha, such as hedge funds, could become a more critical part of any portfolio.
Lastly, hedge funds are a core component within alternative assets.
In recent years, more clients are starting to view alternative assets as essential. Within an asset class, it also pays to take a balanced approach. Alternative assets are “alternative” for a reason; they all come in different shapes. For example, private equity provides alpha but sacrifices liquidity. Meanwhile, real estate provides income, but its returns still broadly follows the equity market cycle. Private lending is not as globally applicable so the pool of opportunity is smaller, and it is also not a liquid solution. So even in a portfolio that already has private equity, real estate, private lending, there is still a role for multi-strategy hedge funds as a provider of uncorrelated returns with reasonable liquidity.
As alternative assets become a more significant part of portfolios, in our view, a well-run multi-strategy hedge fund could be regarded as a core component.
In the final section of this piece, we identify a few common scenarios across our client conversations and examine how multi-strategy hedge funds can help to enhance portfolios.
How a multi-strategy hedge fund can help in different portfolio scenarios
Portfolio Scenario #1: High, concentrated equity exposure
Given the significant equity rally, especially in tech, over the past decade, it is not uncommon for portfolios to be heavily concentrated in growth stocks.
In this scenario, hedge funds become most useful for their diversification benefit, given elevated equity market valuations and our low long-term return expectations for public equities. Although the hedge fund index has become more correlated with equities over the last decade, hedge fund correlations with equities tends to fall during periods of weak equity market performance – suggesting that there is room for strategic diversification.
Portfolio Scenario #2: Large exposure to high yield bonds
Across Asia, we see many portfolios with sizeable allocations to high yield bonds, which on average accounts for about 20% of the overall allocation into the broad FICC asset class among the portfolios we monitor.
This figure is understandable given the search for yield in a low-yield environment but carries with it several idiosyncratic credit risks. For these types of portfolios, hedge funds can generate alpha that is uncorrelated with credit and interest rate risks.
Both types of risks are high on investors' minds right now, with credit concerns emanating out of China and interest rate risks from fears over a tightening Fed. As seen in the chart below, the hedge fund index's correlation with the Bloomberg Barclays Global Aggregate index is 0.18 over the last ten years and rarely exceeds 0.5.
Portfolio Scenario #3: Alternatives exposure is highly concentrated in private equity
Across the portfolios we monitor in Asia, the allocation to private equity is currently about twice as large as hedge funds. Private equity makes sense for those looking to capture both growth and an illiquidity premium over their time horizon. The benefit of multi-strategy hedge fund is that they are more liquid.
Investors can also benefit from outperformance immediately, compared with a much longer life cycle in PE investing. This attribute can be valuable for investors who may want more liquidity within their overall alternative allocation.
In conclusion, while hedge funds have not been able to match the performance of equities over the last decade, the backdrop of high valuations across equities and bonds, and higher macro volatility speaks to an environment where hedge funds can play an important role in a portfolio, as a provider of uncorrelated return with reasonable liquidity. Multi-strategy hedge funds closely match this purpose of diversification and liquidity.
And, as investors start to view alternative assets as essential rather than optional, it is important to have a balanced approach towards investing in this space. Hedge funds, particularly multi-strategy hedge funds have different characteristics that complement other alternative assets like private equity, real estate. For this reason, hedge fund should be viewed as a core component of any allocation into alternative assets.
Hedge Fund Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. For more information, please see http://www.hedgefundresearch.com/index.php?fuse=indices-met
MSCI ACWI Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1987. MXWD includes both emerging and developed world markets.
Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.