Diversified hedge fund programs offer a potential solution in a market where stimulus has led to inflated valuations

Investors need to cope with a new market outlook as worries about inflation and rising interest rates take hold. For many, we believe the solution will lie in hedge funds, which are not restricted to “long-only” investing.  For investors seeking true diversification, which may be crucial in the coming months and years, investing in a diversified hedge fund program may provides that element.

A new paradigm is driving the markets. Investors will have seen that after a strong run in the first half of the year, stock markets worldwide slowed down sharply in the third quarter, some even going into reverse. Bond yields are also rising, as they factor in higher rates of inflation and interest rates.

For some years now, diversification has not paid off. Leveraged exposure to both equities and fixed income has been the way to go. With that backdrop, equity and fixed income, in combination, are historically overvalued.

We've had 13 years of emergency monetary measures. Stimulus size is unprecedented. There is potential for inflation, potentially not unlike the 1970s.

We think right now a diversified hedge fund program is a good option for institutional investors. This isn’t just a cyclical or a timing issue. We are not aiming to time the market. But if you haven't embraced diversification, we think now is probably a good time to start doing so.

We believe hedge funds offer one of the best opportunities for diversification out there. They're the only asset we know that can be structured in a way to provide diversification against both equities and fixed income. They can do so without having to give up much in the way of absolute return. To be clear, our focus is on long-term returns.

It's a really interesting time to think about the risk that these traditional asset classes pose. The number of inbound inquiries that we're receiving shows how timely this is. People are worried about overvaluation.

We can demonstrate statistically that there are two ways to diversify both equity and interest rate risk. One of those is cash. Cash pays nothing, or less than nothing. But the other one is hedge funds.

You can use a diversified hedge fund portfolio to address specific pain points, helping address whatever keeps you awake at night. It may be that you’re worried about how much money you might lose in the equity market, and hedge funds can mitigate that risk. Alternatively, you may be worried about inflation and the risks that poses to your fixed income. Traditional fixed income isn't going to help you get to your long-term goals. We believe hedge funds can be used to address or mitigate that interest rate risk, and also lift the long-term expected return of your portfolio.

How to hedge (fund)

After making the decision to allocate to hedge funds, it is important to do this in a diversified manner.

You should not be trying to tactically allocate to specific strategies. You should not take the risk associated with an individual manager, or even selecting four or five managers. That sort of concentration risk is often uncompensated.  We believe a better approach is to develop a stable, all-weather hedge fund strategy, through a balanced mix of strategies and managers.

We've mentioned diversification from equities and fixed income, and not giving up too much in the way of return. But in addition to those core objectives, we have the objective of an asymmetric return stream. This approach is designed for  portfolios to allow a degree of exposure to the upside, with strong downside protection, too.

It is unrealistic to hope for long-term positive returns from the downside, but strong downside protection is realistic. By managing the potential losses, you can help protect overall capital.

A penny saved is a penny earned, in this case.

Following the global financial crisis, interest in hedge funds intensified, because they preserved capital. In our view having a diversified exposure to a core group of strategies and implementing them with highly rated managers, there is a higher likelihood of achieving the outcomes you want.

Investing is a difficult task, trying to predict an uncertain future view. If you have a very concentrated roster of managers, there's no margin for error, but prudently allocating to 10 or 12 managers, you can potentially reduce the   tail risk greatly.

No free lunch

Hedge funds, even in a widely diversified programme, are not a panacea, but understanding how they work will make them more palatable.

In difficult times, some managers will gate funds, but the lesson from 2008 was not that illiquid investments are bad, it was to match your assets with your liabilities. Gating is a mechanism to help protect the value of the assets and avoid a fire sale. Every investor has the right to disagree with that approach, which is specified in the offering documents.

Finally, the question of fees lingers. The word of hedge funds is an expensive space. Beta, or market returns, are cheap. You can pay substantially more for traditional active management that offers the prospect of alpha.

Hedge funds are a step further on this road, but the sector – if managers are selected using customized criteria – can offer rewards for the expense. Additionally, over the past decade, fees have come down. There are better mechanisms in place, including discounts for asset size or investment duration, crystallization of incentive fees to match redemption rights, etc;  but always remember to focus on the net results.

Hedge funds may offer the diversification you need as we all enter a new market environment – just make sure to cast your net carefully and wide.

Dave McMillan
Dave McMillan
Global CIO, Hedge Funds
Stephen Ewen
Stephen Ewen
Global Deputy CIO, Hedge Fund

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