January 02, 2020
Time to View Hedge Funds through a Different Lens
January 02, 2020
After a lengthy bull market driven by accommodative central bank policy, equities appear expensive, fixed income yields are low and credit spreads are tight. With the outlook for equity and fixed income returns uninspiring, investors may be seeking an alternative source of return stemming from active management. Representing the most unconstrained form of active management, hedge funds can be a compelling source of active management returns free from the unintended market exposures that can be associated with long-only active strategies.
Positioning for the Road Ahead
With the ongoing tug-of-war between fundamentals and valuations, we continue to believe that defensive market posturing is warranted. However, we see an expanded opportunity set for hedge fund strategies that seek to deliver idiosyncratic alpha by focusing on security selection and tightly controlled market factors. These include sector-specialized market neutral long-short equity, niche opportunistic and other relative value strategies, such as fixed income relative value.
Against a backdrop of geopolitical uncertainty and persistently low equity and fixed income volatility levels, long volatility and “tail risk” strategies may also offer particularly compelling contrarian risk/reward potential today. As the name suggests, long volatility strategies tend to exhibit positive correlation to market volatility and negative correlation to equities over most time horizons, delivering positive returns during periods of market turbulence. Tail risk strategies comprise a subset of the long volatility universe that exhibits a high degree of convexity, a payout that is outsized compared to a change in an underlying variable, to large increases in market volatility or declines in equity prices. They are characterized by opportunistic and hedging positions that are intended to deliver positive returns during dramatic market sell-offs. In our view, well-designed portfolios could benefit from appropriately sized allocations to these types of strategies.
While we absolutely see the potential for specific hedge fund strategies to mitigate downside risk during weak and volatile markets, we have not lost sight of the fact that recent industry-level trailing returns have been disappointing. As we’ve said for some time, we think it’s important for investors to expand their view on what hedge funds can and should deliver. Indeed, as we look ahead to 2020, we continue to think about how we can best optimize our hedge fund allocations. While investing in the right strategies and the right managers remains important, we are intensely focused on re-engineering our hedge fund allocations to optimize the performance they deliver. When it comes to hedge fund investing in 2020, we believe it is essential to focus not only on the “where” but also the “how.”
Optimizing the Way Hedge Funds Deliver Returns
Recent trends have made it easier for hedge fund investors to disassemble and reassemble return components with the aim of enhancing performance. (Display 1) At a more granular level, they have provided large hedge investors the opportunity to control elements of strategy implementation, such as target volatility levels and investment restrictions; the ability to use their scale to gain operational and cost efficiencies, particularly with earlier-stage investments; and, access to real-time data and position-level transparency.
For illustrative purposes only.
We believe access to bespoke investment structures is the key to benefiting from these trends. Today, investors are able to access an increasingly large universe of hedge fund strategies in a separately managed account (SMA) structure, whereby they own their portfolios directly, not through a commingled investment. Through SMAs, investors—as owners—have greater control over return, volatility and exposure targets, as well as fees and transparency than would be available through limited partnership participation in a commingled fund. It used to be the case that investors faced limitations on their ability to invest in an SMA format across a wide breadth of strategies. And they often faced negative selection bias because many hedge fund managers didn’t want to create these structures. It is a very different story today, with most managers and investors recognizing the evolution of the industry and the mutual benefits of these structures. Indeed, investors are now able to execute customized vehicles across a wide array of strategies with limited selection bias.
Another industry development worth highlighting is data availability. With advancements in data gathering, storage and transmission, managers have access to more data than ever before. And they are able to synthesize it more efficiently thanks to artificial intelligence/machine learning. For instance, managers used to rely on inventory reports to glean insights about supply and demand dynamics for a given commodity. Today they can view traffic patterns and track shipments via live satellite imagery. Access to more and better data has become a differentiator among managers, with many investors displaying a preference for specialist managers who have incorporated these data sources into their processes.
In our view, a particularly interesting and relevant application of increased data availability is the emerging area of behavioral analytics. Historically, hedge fund investors have had limited ability to impact how managers behave. With increased availability of sophisticated analytics, investors are able to better understand portfolio managers’ tendencies, both conscious and unconscious. For example, portfolio managers may overtrade in times of market stress, or they may tend to hold certain types of positions for longer than they should. Investors with access to such information can monitor manager risk more actively. Further, they can provide feedback in real-time to help managers improve their investment and risk management processes—ultimately improving their performance.
Our investment decision-making has evolved alongside these industry trends. For instance, given the greater industry acceptance of SMAs, we are increasingly focused on accessing hedge fund talent through customized structures. We are taking control of our destiny by ensuring strong alignment of fees, by specifying volatility and exposure targets, and by increasing “structural alpha”—leveraging our scale to achieve trading and borrowing cost efficiencies at the individual structure level that can aggregate to meaningful savings at the portfolio level. We are also taking advantage of increased industry-specific data flow. This can be seen in our preference for equity long-short sector specialists, versus generalists, in areas with favorable stock selection dynamics where specialist expertise can reap the greatest reward.
With traditional asset classes likely to be offering lackluster returns, we believe now is a good time for investors to view hedge funds through a different lens. We are not trying to guess which hedge fund strategies will outperform in the months ahead. Rather, we are focused on controlling our investment outcomes by adjusting all of the levers at our disposal, both structural and data-oriented. We believe that better structures and better data can lead to better investment outcomes.