An objective to generate absolute return
During the past 20 years, two types of asset management developed simultaneously, but with different aims. On one hand, the global equity bull market enabled the classic asset management to evolve in a less sophisticated manner, since the achievements were measured through simple benchmarks (mutual funds versus basket of equity/bond indexes). On the other hand, the hedge funds have been evolving, mainly dedicated to more specific clients (family offices, HWNI, etc). Their development was based on the creation of new assets (futures, convertibles, derivatives), which allowed the creation of appropriate vehicle to play or arbitrate the equivalent market (CTA, convertible arbitrage). Having access to non-usual strategies and non-classic assets, hedge funds are able to achieve their purpose, which is to generate absolute return (create performance and preserve capital ).
Since March 2002 and the development of the equity bear market, the panorama has shifted and classic asset management has to deal with the real investor utility function (investors only want the upside of the markets but not the downside). In bear markets benchmarks are not of great use and what really matters for investors is capital preservation. Their behaviour towards the hedge funds is the same as towards bonds and equity. They follow a risk/reward approach plus the ability of preserving the gains. For the investors, a relevant risk-aversion benchmark is an equity index.
A new asset class made of three major strategies
An analysis based on the S&P allows us to split the hedge fund world into three main strategies:
n the relative value, really decorrelated from usual markets;
n the long short: a call profile with upside capture and downside protection
n the global macro/CTA: a protection in a volatile market with capture of the strong trends.
These strategies are not correlated with each other and a diversified portfolio composed of each one of them is a way to create a real asset class profile. In this field SG Asset Management, subsidiary of French bank Société Générale, has been a leader in Europe and innovative with the creation of a new hedge fund department back in 1999.
Arié Assayag, global head of hedge funds at SG AM stated : “In order to optimise the use of hedge funds, our view is to consider them at different levels:
n as an asset class with a dynamic asset allocation between all hedge fund strategies;
n as a diversification tool with tactical allocation: for example, a long short strategy can complete an equity investment;
n as a technology provider for other asset classes: the overlay strategy such as currency overlay offers a dynamic exposure to an asset risk;
n as an underlying for structured products: many classic investors need specific structures (capital guarantee, regulator approved structures).
Until recently, providers on the hedge fund market used to be niche players or investment bankers. Recent volatile market conditions induced a stronger development of hedge funds as a complete asset class and brought in asset managers. However, hedge funds remain investment vehicles to be managed by real specialists having a strong support and a strong process methodology.
Key factors for choosing a hedge fund
Three major manager capabilities must be considered in order to optimise the choice of a hedge fund:
n Investment process focus: real skills on illiquid and/or specialised markets, strong quantitative and qualitative research abilities, strong conceptualisation and formalisation;
n Risk management: drawdown management and market timing are important points to be incorporated in the portfolio management. This risk management is calibrated to the fund’s objectives and to the underlying risk parameters (volatility, liquidity);
n Client service: the emphasis on reporting and pedagogy is important because hedge funds used as a true asset require a good understanding of their properties and objectives. During the 1990s hedge funds delivered very good performances assuming an equity bull market which profited every investor. If decorrelated from other asset classes, the range of performances is linked with the global market behaviours.
These factors being checked, hedge funds are totally adaptable to current asset management constraints: their long-term objective remains identical to other asset classes vehicles even if they use more sophisticated techniques and technology when markets are not buoyant.
Selection and monitoring: focus on SG AM Alternative Diversified Fund (SADF)
SG Asset Management benefits from the usual French financial market’s approach based on strong quantitative analysis and expertise. When launching its fund of hedge funds programme in 2000, SG AM needed hedge fund specialists dedicated to due diligence and qualitative research. The partnership with Alpha Investment Management Inc, considered last year by pension funds as the leading hedge fund consultant in the US, enables SG AM to provide investors with hedge funds managed with a strong investment process. Thus SG AM’s main fund of hedge funds, the SG AM Alternative Diversified Fund (SADF), is a balanced portfolio investing in 25–30 selected hedge funds. Two stages in the selection process: first determine with Alpha an investable peer group through a bottom-up approach only considering hedge funds with more than $100m under management and three years’ track record. In parallel, the allocation process incorporates market conditions in order to elaborate the strategic and tactical asset allocation. The strategic allocation leads to the optimal weighting of the three strategies (relative value, long short and global macro/CTA). The tactical allocation is done at the strategy level: within the relative value strategy what is the optimal weighting between distressed funds and merge arbitrage funds.
The quality of the investment process and the monitoring of thousands of hedge funds led SG AM to a 5% annual performance with SADF in 2001 which is remarkable because it is slightly above bonds but strongly above equity.
Unlimited perspectives for all investors
Investors are now looking for more specific products. Providing hedge funds in the future to different kinds of clients implies appropriate legal structures and market liquidity. Retail clients, for example, need access to local regulators’ approved fund of hedge funds and guaranteed products based on underlying hedge funds.
But demand also goes to more specific funds of hedge funds. Therefore SG AM has developed a full range of strategies to be proposed through appropriate legal structures: one is focusing on relative value, another on equity strategies and a third is a discovery fund providing access to younger, smaller and promising hedge funds. Finally, a multi-strategy fund investing directly in a selection of single strategy hedge funds is being engineered.
It is now obvious the hedge funds and asset management have really started to work together for the benefit of investors.
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