How do portfolio managers find the needle of alpha in a haystack of hedge funds accused of riding a wave of beta? In an environment where the largest hedge funds are gobbling up the lion’s share of assets under management, look at uncorrelated niche strategies where research coverage is light and markets are capacity constrained, panelists at the Gaining the Edge conference in Chicago told the audience.
While the hedge fund industry has grown exponentially over the last ten years, the primary beneficiary has been the largest hedge funds. But allocating to the biggest is antithetical to finding alpha in the hedge fund industry, those on “The Quest for Alpha” panel asserted.
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“Size is the enemy of performance,” quipped TIFF Managing Director of Diversifying Strategies John Sinclair. He gravitates toward strategies that “go where other people don’t go.” To him, markets or hedge funds that are capacity constrained are positive, but what really lights his fire are managers that materially outperform when the stock market is in decline.
Conference organizer Don Steinbrugge, CEO and founder of Agecroft Partners, told ValueWalk the move towards smaller managers has been part of a longer-term trend followed by sophisticated investors. In 2008, pensions funds wouldn’t look at a fund manager with less than $5 billion in assets under management, he said. Five years later that number was near $2 billion and today it can go as low as $500 million. He noted long fixed income is a category where benchmarks are achieving low returns, near 2%, while niche individual managers are performing around 5% to 7%.
John Frede, director of research for 50 South Capital, the hedge fund allocation arm of parent company Northern Trust, observed that smaller managers can manage risk more effectively. For him, alpha, or individual manager skill, isn’t of value unless it is repeatable.
Finding alpha is a challenge that William Steele III, director of research at Evanston Capital, thinks can be accomplished through a strong research process that has meaningful points of differentiation. He thinks that with central bank policy increasingly diverging, hedge fund managers will increasingly find opportunity.
Although the Federal Reserve left interest rates unchanged Wednesday, Lighthouse Partners Managing Director Clark Prickett said that rising rates isn’t impacting their long-term hedge fund allocation strategy. He notes the trend for rates has been moving lower since for several decades and that, while it may bounce around near the bottom, he expects interest rates to steadily move higher. “As long as the Fed is operating based on the economy and not politics, they are not the problem,” he told the audience the Union League Club. “The days of pure arbitrage are behind us.” Prickett likes to invest in volatility managers while projecting volatility to reach normalized levels in the near future. Also on his allocation list are market neutral options arbitrage strategies, as well as those with sovereign debt plays in Argentina and Venezuela where uncertainty exists, and quant strategies in emerging markets, particularly China. He thinks traditional quant strategies do better in emerging rather than developing markets.
Sinclair, for his part, differentiates between volatility types, with passive volatility not having as much long-term impact as volatility generated by a fundamental economic shift. “Volatility is great” for the funds in which he invests.
The new age of investing is also bench-marked by fund managers adjusting to lower fees. Speaking on a panel regarding the futures of systemic investing, Mohamed Elkordy, a senior portfolio manager at Texas Trust Company, expects to pay lower fees for computer-driven hedge funds than those managed by discretionary, human fund managers. Not everyone agreed. “I am happy to pay higher fees for truly uncorrelated performance,” Prickett stated.
This article first appeared on ValueWalk Premium