The hedge fund renaissance  

“…that wrens make prey where eagles dare not perch”

With good economic news presently being considered bad and bad economic news being considered good, it seems fitting to start an article on the renaissance of hedge funds with a quote from Shakespeare.

Our 2022 Global Wealth Management Investment Survey found around 60% of respondents believe the biggest investment opportunity over the next two years is in diversifying away from traditional equities and bonds. We couldn’t agree more. We believe hedge funds are a great opportunity, especially for wealth managers considering their stagflation playbook. Stagflation is arguably the most challenging environment for traditional assets like equities and bonds, and hedge funds are an “asset class” that carry a cash plus return expectation and the ability to diversify both equity market and interest rate risks.

The macroeconomic environment of the last decade undermined the hedge fund alpha toolkit, instead providing exceptional support for equities. The effect of near zero interest rate policy and QE meant that diversification (i.e. hedge funds) was an opportunity cost.

However, our expectation is equity beta will not be overwhelmingly rewarded over the next decade and we see a renaissance of the benefits of a well-designed hedge fund allocation which can provide a compelling level of return with low correlation to equities and bonds, whilst delivering enhanced downside/upside capture.

Modern portfolio diversification

Equity beta and interest rate risk dominate traditional discretionary investment manager portfolios. We believe hedge funds can be used to add complementary alternative risk exposures, diversifying away systemic risks while adding alpha.

Allocating to hedge funds also helps enables discretionary investment managers to break away from the confines of defined asset class silos by bridging the gap between public and private markets.

Rather than being an asset class, hedge funds are a collection of heterogeneous investment strategies implemented across asset classes, markets and instruments. As hedge funds have agnostic benchmarks and access to a wide range of investment frameworks and strategies, they tend to have low constraints and an ability to access risk and return streams that are not traditionally correlated. We expect this flexibility will be a critical element for client portfolios going forward. The cost of these benefits, however, is a higher fee and a reduction in liquidity

Our view has remained unchanged for nearly 20 years that a carefully constructed portfolio of hedge funds is the best risk-reducing element for a growth portfolio. A well-constructed allocation consists of a low beta to equities and bonds, an asymmetric downside/upside capture ratio, about one third equity volatility, and a compelling return profile of cash plus 3%–4% annually over a full market cycle. We believe these qualities can provide resiliency and ballast to a portfolio.

Macro environment is essential

Despite recent hedge fund risk-adjusted returns being in line with history, absolute performance levels have been suppressed. It is understandable that some criticism has increased with heightened concerns regarding the cost/benefit ratio of hedge funds. While hedge fund debates are often polarising and feature strong views. We believe a significant portion of the suppression is related to the market regime, which has been significantly influenced by policy and regulation. Additionally, many industry averages tend to overlook the potential success achievable through portfolio construction and manager selection.

Between 2000 and 2009, the dot-com bubble and the global financial crisis marked the beginning and end of one of the worst decades for equities in history. The decade that followed was one of the longest and strongest bull markets in history, supported by near zero interest rates and quantitative easing. From 2000 to 2009, hedge funds performed well due to their alternative risk exposures and low betas. However, from 2010 to 2019, a time of excellent stock and bond returns, hedge funds' lower betas and broader diversification proved to be a detriment. We would argue this is somewhat within expectations as hedge funds serve to deliver value during periods when beta is not overwhelmingly rewarded. We also note, this was the average experience as indicated by some of the industry indices and may not reflect individual investor experiences and value add contributions. Nonetheless, the broad brush of results was a more muted return environment throughout the pro-risk policies coming out of the GFC.

Overall, the prevailing macro environment between 2010-2019 undermined the hedge fund alpha toolkit while providing extraordinary support for equities. For hedge funds to keep pace with this growth would have required greater risk-taking either in the form of added leverage, directionality, increased beta or some combination. These are measures we prefer hedge funds to avoid.

Potential benefits of a ‘portfolio approach’

An investment manager who wishes to allocate to hedge funds must determine what role the hedge fund portfolio allocation will play in the client portfolio. Which can vary from risk reduction to return enhancement, as well as portable alpha and portfolio hedging.

When it comes to hedge fund portfolio construction, we strongly advocate a ‘portfolio approach’ along with a philosophy of “prudent concentration” when deciding how many managers a hedge fund allocation should contain; our preference would be 10 to 20 ultra-high quality managers.

We suggest that hedge fund allocations be diversified across multiple alternative returns sources so that a portfolio approach can be achieved. Consequently, the portfolio can win from multiple points of view while minimising potential blind spots and the degree of cyclicality associated with each hedge fund return driver. In order to achieve a level of return driver diversification, one must diversify not only by manager and region, but also by strategy. For example:

• Long/short equity and long/short credit provide bi-directional security selection; 
• Deal and complexity risk are a primary component of event driven investing; 
• Distressed securities benefit from liquidity provision and process risk; 
• Timely variable beta and trade structuring drives successful global macro managers.

Under-representation

A number of factors contribute to the under-representation of hedge funds in wealth management portfolios, including high implementation risks, the lack of true passive alternatives, and the difficulty of rebalancing capital with redemption frequency and advance notice requirements. As a result of challenging market conditions and concerns about future returns, we believe that hedge funds are an essential element of diversification. For these reasons, we believe hedge funds deserve a significant strategic allocation within discretionary multi-asset portfolios, provided they are suitable in terms of complexity and liquidity.

Key Takeaways

• Establish a strategic rather than dynamic long-term allocation at a level that is more easily carried during strong equity markets. 
• Manager strategy and style preference should focus on global multi-strategy hedge funds that have a low leverage profile and utilise both sides of their balance sheet (long and short). Main title – Sub-title 
• Even though in our opinion manager selection is the key determinant of a successful hedge fund investment experience, portfolio construction runs it a close second. 
• Alpha, of course, is not evenly distributed across the universe. We believe that using Mercer’s A-rated selections combined with thoughtful portfolio construction can lead to better than average outcomes, including in the most recent period. 
• We believe hedge funds are particularly attractive over the near to intermediate term. The tails remain fat in today’s market and hedge funds can significantly dampen the impact of tail events.