Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 176

What role should hedge funds play now?

Almost against the better judgement of retail investors, the hedge funds they took speculative bets on during and after the GFC, then quickly abandoned for falling dismally short of their promises, are now creeping back onto their radar.

Unsurprisingly, the 180-degree about-face in investor sentiment is mirroring the recent performance of traditional assets, which after a strong run over the past five years, have unceremoniously fallen. But while they’re being forgiven for not behaving true-to-label when required, only certain pockets of the hedge fund universe are capturing the market’s attention.

What we’re currently witnessing, says Donald Rice, head of Alternative Investments Asia Pacific at Credit Suisse Private Banking, is an admission by investors that relying on traditional asset classes like shares, fixed income and cash isn’t going to get them to where they need to be within a historically low earnings environment. “People had major objections to hedge funds following the GFC, and those who returned have favoured single managers and avoided fund-of-fund managers,” Rice says.

Genuine diversification

What’s becoming clear, adds Rice, is that retail investors’ need for genuine diversification and low correlation to traditional asset classes is driving them towards those hedge funds that deploy market neutral and uncorrelated alternatives to fixed income strategies. Credit Suisse’s allocations to hedge funds are driven by strategic views around the most relevant strategies in the current environment. Currently, some of the favoured strategies include insurance-linked, quantitative funds, and traditional managed futures (sometimes called Commodity Trading Advisors, or CTAs).

“Interest in alpha capture is less algorithmic and more about research and social media,” Rice says. “For one manager, the biggest returns in the last two years are from machine learning, and the implications of this for investors shouldn’t be overlooked.”

Stephen Cabot, head of Investment Consulting Private Banking Australia at Credit Suisse says that with equity markets arguably stretched and fixed income currently where it is, clients want to take some of the allocation out of long only and put it into equity market neutral with low net exposures. “Our clients’ portfolios have typically had between 5 and 20% exposure to hedge funds, but we recommend 20% exposure to alternatives,” he says.

The big-end of town is no different. When Credit Suisse surveyed 369 institutions globally, 87% said they would be increasing their allocation to equity market neutral, and reducing traditional market exposure (or beta) in their portfolios.

“Within markets like this, people have enough beta, and feel comfortable with lower net exposure to the market,” Cabot says. “Rather than shooting the lights out like they were supposed to before the GFC, the role of hedge funds is now less about turbocharged returns and more about stabilising a portfolio composed of bonds and equities with something that’s truly uncorrelated.”

Alternative beta strategies

A longstanding problem with most hedge funds, adds Gareth Abley, head of Alternative Strategies at MLC, is that it’s expensive to pay for market beta wrapped up in a hedge fund, especially when it could be acquired more cheaply on listed equities. While all of Abley’s current hedge fund exposures are offshore, he’s typically attracted to Australian managers with a more diversified exposure. “We prefer managers who exploit the law of large numbers in lots of small bets to achieve a more reliable return stream.”

Abley is attracted to uncorrelated risk premium strategies that don’t rely on the skills of a manager to deliver. He cites natural catastrophe reinsurance or mortgage repayment risk as two examples. MLC didn’t invest in hedge funds until 2007, due to major concerns over having beta wrapped up in a hedge fund, as well as fee and liquidity considerations, but since then allocations have grown steadily.

“They have to be the right hedge funds and this is a very small subset of the universe,” Abley says. These include long/short exposure to factors like quality, value, carry and momentum across different asset classes, and Abley expects this trend to continue. He also expects these alternative beta strategies to achieve a decent risk-adjusted return, which within the current environment is cash plus 3 to 4%, and close to zero correlation to equities.

Dumb luck

Having screened out the 80+% of the hedge fund universe that has too much correlation to equities, Abley has hand-picked a dozen funds for MLC’s portfolios. But due to the difficulty finding those that genuinely stand out after thorough due diligence, there are only 12 hedge fund managers in MLC’s portfolio after 10 years.

One of the biggest dangers confronting investors, warns Abley, is the number of seductive-looking funds with great track records that have got there purely through dumb luck. He uses the analogy of a coin tossing contest. If 10,000 people toss a coin each year, after three years there will be 1,250 that have called heads three times in a row. After five years, there will be 312 that have called heads five years in a row. The problem, he says, is that they may start to believe that they’re skilful. It’s the same with the 10,000 or so hedge funds. While it’s statistically guaranteed that some will have great returns purely from randomness, Abley reminds investors there’s no guarantee they’ll call heads again next year or the year after.

“We’re constantly trying to work out what’s driving returns – luck, skill or a favourable environment for a certain type of strategy,” Abley says. “Performance doesn’t always tell you the right story and if you can find a good manager that’s done poorly for three years, it could be a good time to back them.”

Filters

To select 130 to 140 exposures within clients’ portfolios, Rice uses a four-pillar approach, including legal reviews, market risk management, manager due-diligence, background checks, CFO, team member and third-party service provider checks, plus peer group analysis.

“While we could see merit in a CTA trend-following approach, we’re also not so quick to write-off non-performing quality managers,” Rice says. “It’s important fund performance is understood, and the time may suddenly be right for quality funds that experienced lack-lustre performance over the last two years.”

While Cabot’s clients are keen to invest in both Australian and offshore hedge funds, he admits that certain strategies are harder to access locally. He says it’s less about Australian hedge funds not being sophisticated enough, and more about networks and access to certain markets. “For example, it’s easier for European-based managers to trade distressed credit in Europe,” he says. “For CTA and managed futures, having suitable scale and infrastructure enables US and European trading when those larger markets are open.”

Better transparency

Complementing improving investor sentiment is greater transparency, courtesy of a better post-GFC regulatory environment. But given that it can be a primary source of competitive advantage, disclosure into individual holdings is not something hedge funds are necessarily willing to provide. For example, while it’s no secret that US-based pure alpha fund Bridgewater is MLC’s largest exposure by capital allocation, little is known about the other 11 hedge funds within its portfolio.

But insufficient transparency can come at a price. For, example, when selecting hedge funds, Rice will overlook top performers that refuse to provide sufficient insight into their underlying exposures.

Similarly, investors also lack detail when it comes to fees. While Abley is also reluctant to talk about fees, he concedes it is critical to negotiate strongly for a deal that stacks up net of fees.

“While we don’t mind paying managers fees for delivering high alpha, anything that isn’t alpha is discounted from the return stream and we have no interest in paying hedge fund fees on beta.”

 

Mark Story is Executive Director of Prime Strategy Media and specialises as a financial and business journalist. This article is general information and does not consider individual circumstances.

RELATED ARTICLES

Why bother with hedge funds?

‘Super-defensive equities’ may rescue struggling 60/40 portfolios

Four reasons ESG investing continues to grow

banner

Most viewed in recent weeks

Three steps to planning your spending in retirement

What happens when a superannuation expert sets up his own retirement portfolio using decades of knowledge? He finds he can afford much more investment risk in his portfolio than conventional thinking suggests.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Finding sustainable dividend stocks on the ASX

There is a small universe of companies on the ASX which are reliable dividend payers over five years, are fairly valued and are classified as ‘negligible’ or ‘low’ on both ESG risk and carbon risk.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Latest Updates

Shares

Platinum’s four guiding investment principles

Buying mispriced stocks is often uncomfortable when companies are outside the spotlight and markets are driven by emotions. And it's inescapable that the price paid ultimately determines the end result.

Interviews

Andrew Lockhart on corporate loans as an income alternative

Loans to corporates were the traditional domain of banks, but as investors look for income alternatives to term deposits, funds have combined hundreds of loans into a single structure to create a diversified investment.

Retirement

10 things I learned in my faux-retirement

Pre-retirees should ‘trial run’ their retirements. All those things you want to do - play golf, time with the family, a hobby, write a book - might not be so appealing in reality, but you might discover other benefits.

Retirement

Achieving a sufficient retirement income portfolio

Retirees require a reliable income stream to replace the wages they received when they were working and should focus on the dollar income generated over time rather than the headline yield percentage.

'Wealth of Experience' podcast and ASA webinar on ETFs v LICs

Peter reveals some top stock picks with an emphasis on long-term assets like Sydney Airport, Graham discusses spending in retirement and valuing assets, the key to Amazon, guest Andrew Lockhart and plenty more.

Strategy

Lucy Turnbull’s three lessons on leadership and successful careers

From promoting women to boost culture to taking opportunities as they arise, Lucy Turnbull AO says markets should not drive decision-making and leaders must live and breathe the company's mission and values.

Economy

Are concerns about inflation inflated?

While REITs and some value stocks are considered 'inflation-sensitive' assets, the data provide little support that they are good inflation hedges, and energy stocks and commodities are too volatile. So what works?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.