In theory, hedge funds are all about delivering absolute returns – finding the elusive alpha. Until now, it has been universally accepted that the objective of a hedge fund is to provide positive absolute returns over a medium-term investment horizon irrespective of market environment and traditional market performance. But in practice, hedge funds, just like any other investment product, are subject to market exposure.
Paolo Barbieri, deputy chief executive officer and head of hedge funds at Pioneer Investment, does not believe that hedge funds are totally independent from the market pattern. He says: “Although fund of funds aim to be less dependent on market trends, a certain degree of correlation remains.” Meanwhile, Derek Stewart, director of Mellon Global Alternative Investments, is more circumspect and says: “It is difficult to generalise about fund of hedge funds as each one is different and includes a myriad of styles and strategies. Every strategy has different types of market exposure. For instance, directional trading strategies such as emerging markets, global macro and CTAs are more exposed to currency, equity market and commodities risk, which is why Mellon doesn’t invest in them.” According to Stewart, the level of market exposure depends not only on the strategy itself but also on how the manager executes that particular strategy.
There is no doubt that, as the market becomes more efficient and communications improve, it is becoming increasingly difficult for managers to produce alpha, particularly in relative value strategies. Barbieri explains: “The strategies that used to be relied upon for their inefficiencies, such as convertible and merger arbitrage, don’t work in the same way any more. Managers are either using these strategies in emerging markets or developing new, more sophisticated ways of using them than their peers.” Stewart believes that every strategy has its own lifecycle. He says: “Convertible and merger arbitrage used to have structural inefficiencies but these have largely been arbitraged away, partly due to the number of players in the market.”
But investors need not despair as other areas of the market can produce significant alpha. According to Barbieri, some hedge fund managers are finding alpha by entering areas of the market that have relatively high barriers to entry such as emerging markets or private equity. He adds: “At Pioneer, our product is slightly less liquid than others. In order to obtain low volatility, low tail risk and still get the returns, investors have to be prepared to compromise on liquidity.”
In general, hedge funds are less liquid than they were previously. This is partly due to managers looking for new ways to maximise alpha and increased demand from investors, which has allowed hedge fund managers to demand so-called ‘sticky’ money. The recent constraints placed on the industry by the US regulator, the Securities & Exchange Commission, have also had an impact and many hedge fund managers prefer to lock up the money for two years rather than have to register the fund.
But some industry participants feel that we are using the wrong terminology. Stewart thinks hedge funds are often described in this way because a number of managers have made the transition from the long-only world to hedge funds and are used to thinking in these terms. This familiar vocabulary is also comforting for the recent influx of institutional investors to the asset class. Instead of using the terms alpha and beta, Stewart prefers to consider the structural inefficiencies inherent in the strategy. He explains: “Large institutions talk about alpha and beta but this is nothing but a measure of a stock’s particular characteristics at a particular time relative to a benchmark and does not help to evaluate the future value of the stock. The most successful managers think in terms of the value of the company and the upside/downside risk, not about alpha or beta.”
Hedge fund managers have different market exposure biases, which the fund of funds manager has to take into account when assessing and comparing the skill component of managers. This is usually done through tactical allocation between hedge fund strategies. According to Barbieri, having a very deep knowledge of each underlying manager and understanding how each single fund would react in different market conditions, and in case of major market events, is key when constructing a portfolio.

Fund of funds managers have to be conscious of the risks involved when putting together a portfolio. Stewart remarks: “Most fund of funds put a portfolio together based on historical risk returns but this is risky as there is no guarantee that funds will repeat their past behaviour. At Mellon, the risk reward potential of the portfolio is based on supply and demand in the market and is constantly adjusted.”
Depending on the objective of the vehicle, Mellon will take account of factors such as interest rates, equity market direction, bond market direction and credit spreads and their potential impact on the portfolio. Mellon also diversifies by geographic region and by market cap and market style. Stewart adds: “All of the managers of our underlying hedge funds hedge currencies so we have no exposure”.
When constructing a portfolio of underlying hedge fund managers, Stewart will always take the risk factors and the opportunity set into consideration. He says: “Our objective is to mitigate market risk exposure by blending different strategies together. This said, some risks are worth taking because of the potential returns involved.”
But in an environment where single-digit returns have become the norm, not everyone is taking risks. In fact, Barbieri is concerned that the level of risk taken by some hedge fund managers is lower than it should be. This could prove to be a problem in the future. He says: “A number of institutional investors are stopping hedge fund managers from taking an appropriate level of risk. This is due to a typical misconception among institutional investors and hedge fund managers, who do not differentiate between risk management and the level of risk taken. The new wave of investors is looking for controlled risk and not necessarily low risk.”
This fear of risk taking is partly due to a lack of understanding about the industry. Barbieri feels that investors are not always realistic about what hedge funds can deliver and are looking for something that fund of funds cannot offer. In a worst case scenario, investor disappointment could lead to a substantial amount of money leaving the market at once, which would be damaging to the industry as a whole. He says: “We have to educate institutional investors and manage their expectations.”
It is clear that without alpha the hedge fund industry would not exist as the ability to produce absolute returns is the defining characteristic of a hedge fund. Barbieri remarks: “Looking for alpha is our mission, if a hedge fund can’t produce it, it isn’t a hedge fund.”
Stewart goes as far as to say that some traditional long only managers are only masquerading as hedge fund managers. He says: “At the moment, barriers to entry are low in this market because investor demand is so great. But there are many managers who we don’t consider to be true hedge fund managers because they take a long view of the market.”
Hedge funds are not always
synonymous with absolute returns and, depending on the strategy selected and the way it is executed, will be subject to varying levels of market exposure. It therefore
follows that a fund of funds is not an absolute return vehicle. Instead, it will have a market exposure bias, which will perform
differently in different market environments. Although this
market exposure cannot be completely eradicated, a well-chosen fund of funds manager should be able to mitigate it, leaving the investor significantly less exposed to the inherent biases of the underlying hedge funds.