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Hedge Funds: Role As Substitutes And Diversifiers

Examining The Roles Of Hedge Funds As Substitutes And Diversifiers In An Investor Portfolio by AIMA and the CAIA Association

Introduction

It is time to think about hedge funds in a new way.

The old distinctions that have underpinned portfolio construction for at least the last 25 years are rapidly disappearing. Many of the most experienced hedge fund allocators worldwide no longer see hedge funds as a separate bucket ? ring-fenced, somehow, from the “traditional” assets in a portfolio ? but as substitutes for long-only investments and diversifiers capable of transforming the risk and return characteristics of their entire portfolios.

Take the substitutes. Those investors who, for example, are now choosing to replace some of their long-only equities allocation with an equity hedge fund are not merely substituting a long-only allocation with a hedged position. They are also improving the way their portfolio as a whole performs under a variety of market conditions due to hedge funds’ superior risk-adjusted characteristics over time. The result of all this ? the capital of the investor is better preserved while its’ volatility is also reduced across the entire equities allocation.

Some hedge funds are simply too uncorrelated to equities, say, to be a straight swap ? since the way they behave under certain market conditions is substantially different to the way the underlying asset class behaves. These hedge funds are not regarded by hedge fund allocators as substitutes, but as diversifiers.

All hedge funds offer diversification. But the diversifiers (in this context) comprise hedge fund strategies that are particularly uncorrelated to the underlying traditional assets in the portfolio ? and thus, provide the potential for significant diversification and the highest possibility of generating out-performance.

Which hedge funds are substitutes and which are diversifiers? For this paper, new analysis has been undertaken ? using a statistical method known as cluster analysis ? to accurately categorize the risk and return characteristics of the main hedge fund strategy types. This is what the analysis has found:

Substitutes

  • Long/short equity funds
  • Long/short credit funds
  • Event driven funds
  • Fixed income arbitrage funds
  • Convertible arbitrage funds
  • Emerging markets funds

Diversifiers

  • Global macro funds
  • Managed futures funds/CTAs
  • Equity market-neutral funds

Thinking of hedge funds as substitutes or diversifiers poses an intriguing, final question: what is the optimum split in a portfolio between hedge funds and long-only investments? We do not, in this paper, seek to answer this question directly, since we recognise that institutional investors are not a homogeneous group. Pensions, endowments, foundations, insurers and family offices are very different entities, with different challenges and divergent aims and objectives.

But the logical conclusion of this new thinking points to a future in which investors no longer have a target hedge fund allocation in mind ? say, 15% or 20% of the total portfolio ? but rather, they view hedge funds as another method of investing in equities, bonds or other asset classes. It is transformative thinking.

Note: This paper assumes a level of understanding that at a minimum, investment advisors or their equivalent at pension plans (and/or their equivalent standing at other investor types) should understand.

Different Investment Portfolios for Different Investment Mandates

Pensions, sovereign wealth funds, endowments and foundations, insurers and family offices have different aims and objectives.

Goals and objectives differ depending on the investor mandate.

These different mandates lead to different overall asset allocations and risk return profiles with the inclusion of hedge funds performing different roles to satisfy different objectives.

Hedge fund investors are heterogeneous in nature, with each having their own unique risk and return characteristics. This leads to different overall asset allocations by the investor with the inclusion of hedge funds being deployed to perform different roles to satisfy different objectives.

1. Endowments & Foundations:

A commonly stated objective of an endowment or foundation (E&F) is to generate a reasonable level of predictable cash flows (after adjusting for all levels of spending and inflation), to grow the value of its investment fund and maintain the capital in real terms over the long term whilst providing an annual income to support its activities.

E&F portfolios are typically pools of assets designed to run in perpetuity while striving to deliver some pre-established spending amount over the course of a year. For example, in the U.S., governing statutes require that foundations pay out a minimum amount (usually 5% of the average trailing three-year total market value of the portfolio) to satisfy the required tax treatment or status of its plan. Managing assets under this structure is likely to dictate a certain investment mandate which requires the construction of a portfolio comprised of long-term investments across a diversified range of assets (e.g., stocks, bonds, real assets) that will deliver sustainable, risk-adjusted results. Changes in the inflation rate can affect the level of the plan’s future income derived from any donations and bequests made. Given this strong sensitivity, this often results in the CIO of an E&F plan making large allocations to inflation-sensitive and real return assets, such as commodities, real estate, infrastructure, timberland and farmland.

A prolonged bear market and/or a severe economic recession can cause a reduction in any contributions and bequests to an E&F investment plan, ultimately threatening the prospect of it being able to match its required spending rate.

Confronting these challenges opens up a special niche for alternative investments such as hedge funds to be allocated to an E&F portfolio. The proven ability of hedge funds to protect an investor’s capital when it is highly correlated to underlying market positions and generate high long-term returns by exploiting market inefficiencies makes hedge funds attractive to E&Fs.

The landscape of endowments investing in hedge funds is largely made up of US institutions; 94% of active endowments globally are based in the US. Notably, Yale and Harvard university endowments have pioneered a model2 for the large scale use of alternative assets, including hedge funds and private equity.

With long-term time horizons, E&Fs are able to take a long term approach to their investment in hedge funds. Further, they are generally more able to tolerate more illiquidity and longer lock-ups compared to other investors.

Hedge Funds

Hedge Funds

Hedge Funds

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