Hedge Funds: Angling for alpha: pension funds talk hedge funds
When he isn't managing the alpha traders at Denmark's state pension fund, ATP Alpha CEO Fredrik Martinsson likes nothing better than to get out with his rod and line - so it's no surprise that he reaches for an angling metaphor to explain his understanding of alpha.
"Let's say that we both fish in Lake Equity," he says. "You fish for carp, which is a nocturnal bottom-feeder, and I fish for trout, which hunt during the day for prey on the surface. So you leave baits on the bed of the lake in the evening and I come along in the morning to do my fly-fishing. What's the likelihood of us both enjoying similar-sized catches on the same day? Very small. Now let's say we both fish for trout, but you fish in Lake Equity and I fish in Lake Bonds. Then, I think, we are more likely to be lucky or unlucky on the same day. The deep-value equity investor is more likely to be correlated with the relative-value fixed income investor than the two equity teams I have here, who are looking for totally different alpha sources."
What we think of as ‘hedge fund strategies' are not an asset class: they are ways of extracting certain risks from, and thereby changing the return distributions of, traditional asset classes. But ATP does regard alpha as a ‘risk class' in an important way. It allocates risk to five fairly traditional risk classes - equity, credit, nominal rates, inflation and commodities - identified as exhibiting different risk profiles. Alpha is not so much ‘separated' from these - it is regarded as the ‘sixth risk class' alongside them. It is therefore required to be a different risk from the more traditional portfolio or its constituents. "Otherwise there is a far simpler way for ATP to replicate what we do," Martinsson reasons.
This is not about crash or ‘Black Swan' protection. That is done with options by the traditional portfolio's trading desks: ATP's alpha risks must deliver a certain risk-adjusted return and an opportunity scalable enough to move the needle for the whole portfolio. Two rising time series will necessarily show some form of correlation with one another over time. The key is to determine the extent to which this is a statistical accident or a causal relationship. Hence, process is as important to ATP Alpha as statistics.
Indeed, there is a whole family of strategies - put-option writing strategies or some flavours of credit arbitrage that offer leveraged short-volatility exposure - that can build up huge tail risk even as their returns show zero correlation with traditional assets. "Those traders end up with the money and their investors end up with the experience," Martinsson says. "We deal with these strategies by putting a lot of emphasis on the investment process being logical and firmly understood by the management team."
That is why Martinsson rates the transparency of an in-house operation so highly - saying that your process is all about a, b and c is one thing - keeping it that way is quite another.
"Real-time position-level transparency allows us to see that our teams are behaving in accordance with their stated investment processes," says Martinsson, "and the fact that we allocate risk rather than capital allows us to utilise cash more effectively."
Unfortunately, allocating capital (rather than risk) to an unpredictable process (rather than one over which they have transparency and influence) is a problem other pension fund investors have to live with. Are they able to think about their hedge fund portfolios similarly to the way ATP conceives its alpha portfolio? The experience of the more sophisticated investors suggests they can.
In the UK, for example, the Universities Superannuation Scheme (USS) splits its allocation into core, tactical and niche porftfolios. Tactical is all about cyclical opportunities that change with the macro environment (convertible bonds, distressed debt and merger arbitrage, for example).
Niche is anything that is non-correlated with the main beta portfolio but not as scalable as core, which head of alternatives Mike Powell described as being about "long-optionality to reduce the left tail of the scheme" when he spoke with IPE this summer. This sounds like a ‘Black Swan' portfolio, but really it is made up of strategies that actively manage volatility for an absolute return - long/short equity with low average net exposure, managed futures, global macro and trading-oriented credit funds. "The ability to customise exposure is important," Powell confirmed. "Diversified funds of funds get you very generic exposure. Our hedge fund programme doesn't look like an off-the-shelf product."
At the Barclays UK Retirement Fund there is perhaps greater acknowledgement that the systematic risks might begin to dominate the alpha in external products. High-alpha, low-beta strategies like global macro go into an ‘alternatives' bucket. There is a niche portfolio that is also less focused on integration with the main part of the fund, as well as a concentrated, high-alpha fund of funds allocation, but most of its hedge funds are positioned according to their defining systematic risks. As head of manager selection Andre Konstantinow told IPE this summer: "We try not to silo too much in ‘alternatives' because it's better to think about where you can add value to the other parts of your portfolio."
VER in Finland, which started re-thinking its hedge fund portfolio in 2008, has also been augmenting its core multi-strategy fund of funds with single-manager allocations that reflect a greater concern to isolate the most complementary risks. "In the opportunistic bucket we have preferred closed-ended structures with back ended performance fees," says portfolio manager for absolute return strategies, Antti Vartiainen. "These are currently focused on distressed credit. In our direct fund investments we allocate to funds that are generally not correlated to our long-only investments and to the general hedge fund indices. These currently consist of some rates strategies and GTAA strategies."
Those investors venturing beyond off-the-shelf diversified products usually do so as a result of re-thinking the purpose of hedge fund investing - moving away from the idea that they are simply allocating to another kind of asset class. "Having a clear understanding of the objective of the alpha or hedge fund investments should be the ex-ante starting point for any pension fund," says Martinsson. "If it's about crash protection against specific tail-risk events deemed too painful for the main balanced portfolio, there are other, more efficient ways of doing that."
If the objective is diversification, that's one strating point; if it's better risk-adjusted exposure to risk premiums, that's another. As USS, Barclays and VER demonstrate, it is possible to use hedge funds to meet all of these needs, but in doing so, they build separate portfolios with those distinct objectives firmly in mind.