On the Record: The volatility question
We asked two European pension funds how they view, and invest in, the hedge fund sector at a time when volatility is structurally low
Hedge funds no longer deliver
In recent years we have downsized our allocation to hedge funds due to concerns over performance. We allocate 40% of our assets to non public investments, half of which is real estate. The other half is private debt, private equity and some hedge fund investments.
In my view, there are three reasons why hedge funds no longer deliver the alpha they used to. First, the fact that in recent years central banks have ‘stolen’ the volatility from markets by keeping interest rates so low. Second, regulations means banks can no longer offer leverage at the cost they used to.
Third, competition among hedge funds has risen as more people have learned the trade. Investors, in general, are more aware of how hedge fund strategies work and this means some positions are easier to replicate, for example through risk premia strategies which can be used as ‘hedge fund building blocks’, and this tends to make strategies more crowded. To sum up; the behaviour of markets has changed and hedge funds are no longer able to capitalise on imperfections, which are not as abundant.
Having said that, there will always be individual managers or strategies that have the prerequisites to outperform, but they will be rare. However, for an investor like myself, it is very hard to justify spending too much time trying to find managers that can deliver alpha since even the most skillful managers might not be consistently doing that.
These arguments are mainly related to traditional hedge funds, those that used sophisticated trading strategies in tradable assets. In private markets, managers can still deliver alpha, and certain private market strategies can be classified as hedge funds. However not everyone can access investments in private markets easily. Investors need a lot of expertise and experience. The dispersion between managers outcome is much higher than in benchmark-driven UCITS funds. Again, if one does not have time to do their homework I would propose private markets are not the solution.
It has simply become harder to build a portfolio that has an uncorrelated risk/return profile. Nowadays, investors can easily find themselves into a situation where they cannot reach their return target and they cannot lower it at the same time, since they do not have a sponsor that can put in extra capital. The wisest possible advice for those who must preserve capital today is to accept that you will not reach your return target and to avoid adding risk at the end of this credit cycle.
Volatility must come back
We have both externally-managed hedge fund strategies and internal absolute return-type investments. They are both very diversified portfolios and it has taken quite some time to build them. We already had both external and internal strategies when I joined more than 10 years ago.
The externally-managed portfolio focuses on multi-strategy funds, including global macro strategies and distressed credit. The internal portfolio is a function of the skills we have developed, and invests with a number of approaches. At the moment, the largest segment is a relative-value strategy focused on fixed income. We also have volatility-based strategies investing in currencies, interest rates, single-name equities and commodities, as well as a systematic risk premia strategy. The trading activities are managed internally.
We feel that our portfolio of absolute return investments brings strong diversification benefits to Ilmarinen’s total balance sheet over a long-term horizon. Obviously, we scrutinise and evaluate each strategy on a standalone basis and assess which other strategies may be attractive at any given time.
The portfolio takes into account the changes that have occurred in the markets over recent years. It is quite clear that central bank action has evolved into a strategy of yield curve control. The European yield curve does not move and this is reflected in the volatility of currencies and other assets. The realised volatility has come down significantly, and the European rate market is far from efficient. Central banks have tamed the markets.
With less volatility, there are fewer opportunities for alpha-driven strategies. We have to be increasingly careful when constructing our positions, particularly when we try to build some convexity or long-volatility positions.
It has become particularly difficult to spot attractive risks. When one does and takes exposure to those risks, it does not take very long before other investors join and those positions become crowded. Unwinding those positions then becomes difficult because everyone else will be doing it at the same time.
On the other hand, financial markets will probably always behave in this way. There will be periods when volatility is low and periods when it is high. Regimes change and it is by definition impossible to say when they do. However, I think it would be fairly aggressive to say that we will never go back to a higher volatility regime. Central banks are playing a fairly big role in this environment and when they stop, volatility must come back.
A separate question when investing in hedge funds is transparency. How transparent we want and can expect our hedge fund managers to be will be a key question. Generally speaking, we would want them to be more transparent than they are now, but at the same time we understand that there are limits in terms of how transparent they can be.
Interviews by Carlo Svaluto Moreolo