Hedge funds: the missing piece of your portfolio?

A great investor once said: “Risk comes from not knowing what you’re doing.” Of course, it’s hard to imagine that there is much that Warren Buffet doesn’t understand about investing. But for us mere mortals, how much do we need to know about multi-strategy hedge funds — or hedge fund-of-funds — in order to use them in client portfolios?

If funds flow is any indication, advisers do not yet feel as comfortable allocating to hedge fund-of-funds as they do to, say, long/short funds. You would be hard pressed to find a recommended dealer group list that does not feature long/short equity funds, but the same cannot be said for hedge fund-of-funds. Allocations, if made at all, remain at the few per cent level.

What exactly is a hedge fund-of-funds?

“The manager chooses a portfolio of hedge fund strategies and managers — there may be as many as 20 to 30 strategies/sub-strategies, and 50 to 100 managers,” says Select Asset Management’s chief investment officer Dominic McCormick. The aim, he says, is a fund that is so diversified it is largely uncorrelated with mainstream asset markets.

“Hedge fund-of-funds are targeting a low level of volatility and modest absolute return, as are most of the underlying managers,” he adds.

How much does an adviser need to understand about the underlying strategies?

“A lack of full understanding of the area is a flawed reason not to make hedge funds a core component of many client portfolios,” says McCormick.

“In a conventional fund, investors pay a fund manager to understand the management, strategies and valuations of the companies they invest in,” he points out, adding that if an adviser had that level of understanding, they would no doubt dispense with using a fund and pick the stocks themselves.

Similarly, it’s the job of the hedge fund-of-funds manager, not the adviser, to understand all the strategies used in the fund, and to know the underlying hedge managers, argues McCormick. By extension, in order to use a hedge fund-of-fund, advisers need to understand much the same things as they do to use any other fund, he says.

“It is the likely characteristics of the overall hedge fund-of-funds portfolio that matters most. The important element to assess is the skills and resources of the overall manager, and to understand the broad risk and return characteristics of the fund, and how it interacts with the rest of the client’s portfolio.”

Mercer Investment Consulting’s Rashmi Mehrotra disagrees with McCormick. “I also believe advisers need to understand the performance characteristics of hedge fund-of-funds, in order to set investor expectations. Advisers also need to understand how likely it is that the fund will achieve that, and what conditions need to exist to do so. And advisers need to understand the risk and return of hedge funds relative to other investments.”

But Mehrotra goes one further. She advocates that advisers understand the building blocks of the four or five key hedge fund strategies, so they have a better grasp of how different strategies perform in different markets.

“Hedge fund managers don’t have thousands of unique major strategies,” she says. “Most fall into one of four broad categories — relative value, event driven, equity hedge and global macro.”

She likens it to the understanding that advisers have of multi-sector funds. “Most advisers understand asset class and diversified fund characteristics, even though they outsource the investment management function to professional investment managers. The adviser needs to assess hedge fund-of-funds managers’ skills — how is that possible if the adviser doesn’t understand what the manager broadly does in managing the fund?”

What are the risks?

“There is a higher degree of confidence and less future variability in the risk/return characteristics of hedge fund-of-funds than in most asset classes,” argues McCormick. “The risk of a negative return in any one year is very low.” In contrast, a long-only equity fund can have highly variable 10-year rolling returns, let alone one-year rolling returns, he points out.

But, warns Mehrotra, “advisers should understand not to take the cash plus X per cent target for granted. Over the past three years, managers of hedge fund-of-funds have reduced their target returns from 12 to 15 per cent on an absolute basis, to cash plus 3 to 5 per cent”.

And, she warns, hedge funds do not always give absolute returns, citing academic research that shows hedge fund returns have largely been a consequence of underlying market (beta) positions, and much less the result of ingenious trading capability (alpha).

Tim Farrelly, the principal of specialist asset allocation research house, Farrelly’s, sees three key risks inherent in hedge fund-of-funds.

“Firstly, there is the risk that too many dollars will chase too few opportunities while paying too high fees,” he says. He rates this as a very real possibility, with a one-in-three chance of occurring. If it came to pass, we would see hedge fund-of-funds returns at around 3 per cent per year, some 2 per cent below cash rates, for the next decade.

The other risks identified are less likely, Farrelly believes. “We often hear that there’s a danger that a long-term equities bear market could drag down hedge fund-of-funds returns,” says Farrelly. “However, the data indicates that while hedge funds prefer bull markets, they can still produce tolerable long-term returns in bear markets.”

And the big risk? “The one we hear about the most is a market meltdown. The idea is that we may get a series of ‘five standard deviation’ events, where a series of things that are supposed to be statistically impossible actually do come to fruition, triggering a chain reaction of further, supposedly impossible events.” He rates this likelihood as a one in 50 (2 per cent) chance, and says that, in the long-term, the industry would recover.

When should advisers include hedge fund-of-funds in portfolios?

“It always surprises me that investors and advisers will happily place up to 80 per cent of a portfolio in a few long-only equity funds that could easily lose 20 to 50 per cent in bear markets. Yet they baulk at putting money in a hedge fund-of-funds, where the risk of a negative return in any one year is very low,” says McCormick.

He adds: “As an allocator of monies across both mainstream funds and hedge fund-of-funds, I can assure you it’s the equity funds that cause me to lose sleep on an ongoing basis.”

But in fairness to advisers, most dealer groups outsource asset allocation research to one of the public investment research houses. They are quick to point out that they cannot second guess their research house, not the least because, for many, their Australian Financial Services licences depend on the dealer group following their research house’s advice.

And the research houses can’t agree on how to classify hedge fund-of-funds, let alone how much to allocate, and for which type of investor. For example, van Eyk puts hedge fund-of-funds firmly in the alternatives category, as does Mercer. “We believe them to be truly alternative because they can not be easily replicated through mainstream investments,” says van Eyk’s Alicia Gee.

But Zenith Partners disagrees. “The term ‘alternatives’ has been used as a catch all to describe just about anything that isn’t mainstream,” says Zenith’s David Wright. “We deliberately try not to categorise asset classes or investment capabilities within the alternatives category. So, for example, we believe private equity has equity characteristics and should therefore be categorised as Australian or international equities.”

He adds: “Single strategy hedge funds should be categorised as another investment strategy within the asset class in which they invest. So hedge fund-of-funds are categorised as diversified funds.”

Farrelly’s has a different perspective again, treating hedge fund-of-funds as their own asset class. “A single asset class of hedge fund-of-funds makes sense,” says Farrelly. “When we define an asset class, we use two tests: predictability and investability. Hedge fund-of-funds meets both criteria.”

He explains that when a hedge fund-of-funds manager brings together a number of hedge fund managers in an essentially market neutral fund, they are trying to diversify away all those different factors until all that is left is alpha.

“The forecasting task is to estimate an achievable level of alpha — no mean task, but fundamentally easier than thinking about all the different hedge fund subtypes,” he says, adding that Farrelly’s current 10-year forecast for the asset class is cash plus 2 per cent per year. That’s a little under half of the historic premium of 5 per cent over cash.

“The investability criterion is also met, as investors now have access to a range of hedge fund-of-funds.”

There’s also no consensus as to who should invest in hedge fund-of-funds. Mercer recommends their use with investors with low risk tolerances. So too does Zenith, with the caveat that the underlying fund managers not be highly leveraged.

Farrelly’s recommends hedge fund-of-funds be used in more conservative portfolios too, but also includes them in its higher risk portfolios, albeit with lower allocations. Van Eyk, on the other hand, effectively advocates hedge fund-of-funds for all but conservative investors. It recommends investment in a pool of alternative assets (including hedge fund-of-funds) for balanced, growth and high growth portfolios.

Deirdre Keown is managing editor of PortfolioConstruction Forum.