The Role of Hedge Funds in an Investment Strategy
A carefully constructed hedge fund allocation has the potential to deliver compelling sources of investment returns whilst offering genuine diversification benefits. However, we would highlight the importance of manager selection and portfolio construction in the hedge fund space to fully benefit from their diversifying and return enhancing potential.
This paper looks at the definition of a hedge fund, the evolution of the hedge fund industry, different hedge fund strategies available and the challenges associated with hedge funds.
What is a Hedge Fund?
According to Wikipedia, a hedge fund is “an investment fund that pools capital from accredited investors or institutional investors and invests in a variety of assets, often with complicated portfolio-construction and risk management techniques.”
But what does that mean?
The traditional description of a hedge fund is an investment vehicle that uses leverage and other sophisticated techniques in order to generate returns for investors. Some of the original hedge funds would pair long and short positions together to hedge market risk¹. The term “hedge fund” has stuck since.
Over time the types and nature of hedge funds have expanded. Today, the hedge fund industry is highly diverse, encompassing many strategies, many of which don’t use shorting. The aim is often to deliver returns that are more stable and unrelated to the broad equity or bond markets. In other words, they aim to deliver uncorrelated returns, although this cannot be guaranteed.
Hedge funds are able to achieve their objectives by reducing or removing constraints associated with traditional investment strategies. In effect this means hedge funds have greater flexibility in their investment mandate, as well as the ability to be more sophisticated in the techniques and instruments they employ.
A restriction on short-selling is an example of a constraint that is often not present in hedge funds. In comparison with a traditional long-only equity fund manager, who can only express an opinion that a stock is overvalued by not holding it in their portfolio, a long-short equity hedge fund manager is able to explicitly profit from this perceived overvaluation by selling the stock short and earning a return if the stock price falls.
This increased sophistication and flexibility means hedge funds have the potential to offer investors a return stream which is less correlated to the broad capital markets. A particularly attractive feature of this return stream is the ability to preserve value during periods of weak performance for traditional risky assets.
While it can be seen in the above chart that hedge funds did not capture all of the upside of equity markets, they have delivered significant downside protection compared with that of equity markets over the last 30 years.
The Evolution of Hedge Funds
Hedge funds first started gaining investors’ attention in the 1990s. Hedge Fund Research (HFR) estimates that the hedge fund industry managed US$39 billion in 1990 and US$456 billion by the end of that decade. The average fund size was US$111 million, and many funds were not far from the proverbial two people and a dog running the business from their garage.
Returns for hedge funds were outstanding in this period. Not only did hedge funds outperform equities and bonds, their correlations were low. Adding hedge funds to a portfolio in this period successfully reduced risk and enhanced returns.
Since the 1990s, hedge funds have seen significant inflows, primarily from institutional investors who had institutional expectations for their asset managers, requiring funds to hire client service professionals and answer information requests that in the past would have elicited a “that’s confidential” response. By the end of 2017, industry assets grew to $3.2 trillion, with hedge funds managing over 7 times as many dollars as they did at the end of 1999.
Hedge funds managed small gains in the 2000-2002 equity market sell-off. Returns over that period were attractive, although not quite as strong as the previous decade. They had a down year in 2008 amid the global financial crisis but suffered much less than equities and still looked attractive over the 2000 to 2008 period.
The Global Financial Crisis led to a difficult market environment for hedge fund strategies. Central banks around the world decided to prop up markets and suppress volatility. Governments constrained the market’s “invisible hand” in ways that made it tough sledding for hedge funds. It is not hard to imagine that some of the strategies that worked well in the 1990s were no longer as impactful with seven times as many dollars chasing those opportunities.
As seen on the graph above, hedge funds lagged equity markets with increased correlations over this period. It is very unlikely that the hedge fund industry will be able to generate the types of returns it did 20 years ago. Most funds have grown too big and become too institutional (too much overhead to be as agile as they were in the 1990s). More recent returns have been impacted by the market environment of low rates, low volatility and other consequences of government intervention.
Looking forward we expect to see market conditions normalize. Hedge funds have the potential to be more attractive than they were in the past decade, but they will not be the rock stars they were in the 1990s.
It is important for investors to determine the objective(s) of their hedge fund allocation before selecting the actual funds. It is difficult to be good at everything, so prioritizing expectations is a key input during portfolio construction. Is diversification key? Does return generation trump everything else? How illiquid and esoteric can the funds be? These questions should be specified at the beginning.
Hedge Fund Strategies
A carefully constructed portfolio of hedge funds can play a number of roles in an investor’s portfolio; including delivering absolute returns and providing diversification, thereby reducing the level of risk (volatility) at the overall portfolio level.
Hedge funds are not a homogenous asset class, with managers employing many strategies and specialisations to generate returns.
Strategies typically fall into one of four categories:
- Relative Value: Strategies which profit from price discrepancies across related securities
- Examples include: Equity or Credit Long/Short and Structured Credit
- Macro: A strategy which takes a position on macro-economic views of the market.
- Examples include: Discretionary Macro, Managed Futures
- Opportunistic: These strategies invest based on events or market dislocations.
- Examples include: Merger Arbitrage, Distressed Debt, Drawdown Funds
- Orthogonal: Strategies that are fundamentally uncorrelated to financial markets.
- Examples include: Insurance Linked Securities, Volatility Arbitrage
The level of diversification from traditional asset classes provided by these strategies varies. The graph below demonstrates the heterogeneity of performance by strategy and the importance of strategy allocation and robust portfolio construction.
Possible Challenges to Investing in Hedge Funds
There are risks and obstacles to creating a diversified portfolio of hedge funds, some of the main ones are described below.
Manager selection and portfolio construction
Hedge funds’ success is largely built on the sophistication and flexibility of their approach which allows them to quickly take advantage of market opportunities as they arise, as well as to reduce their market exposure at times of stress. They also employ specialised knowledge to analyze complex securities and unusual situations. This means manager skill, or ‘alpha’, is a much larger component of hedge fund returns than other asset classes, such as equities and bonds, and consequently selecting a high-quality manager is a more critical task than for other types of asset classes.
This refers to the risk of a fund not being able at all times to meet its obligations to pay investors, creditors and other counterparties. Complexities arise when, for example liquidity in certain market segments dries up, making it difficult to dispose of assets when cash is needed. Most hedge fund products offer monthly or quarterly liquidity, subject to a certain notice period. They also may place restrictions on withdrawals during adverse market conditions known as “gating”. It is important that investors are clear about the terms of withdrawal and liquidity.
Hedge funds have experienced a significant amount of bad press over the years, ranging from the Long Term Capital Management blow up, to the Madoff Ponzi scheme scandal to being accused of “causing the financial crisis”. This again underlines the importance of appropriate due diligence and manager selection.
Hedge fund managers often add a performance related fee to a traditional base fee. Typical management fees are 1–2% of invested assets and performance fees are often 20% of realised returns. It is important to note that nearly all hedge fund managers report their performance on a net of fees basis, unlike many other asset management products.
Some hedge fund strategies are extremely complex; investors should be comfortable with their understanding of the fund(s). Also, managers can be reluctant to reveal details of their investment process and portfolio positions as it may limit their competitive edge. Again, this underlines the importance of manager selection and due diligence. Aon insists on full transparency from managers and failure to provide it will result in an automatic ‘Sell’ rating.
In recent years, where extraordinary central bank policies have meant that a straightforward passive allocation to equity and bond markets would have delivered attractive, smooth and cheap returns, it would be easy for investors to become disenchanted with expensive looking and complicated hedge funds. However, a carefully constructed hedge fund allocation has the potential to offer compelling sources of investment returns, volatility reduction and downside protection.
Given the wide variety of hedge fund strategies and significant dispersion in performance between managers within those strategies, robust portfolio construction and rigorous manager selection are essential in order for investors to ensure they maximize the impact of an allocation to hedge funds on their overall portfolio.
1 Buying stocks is known as taking a long position; Shorting is essentially borrowing shares and selling them
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