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Risk & Portfolio Construction: Taming alpha, harnessing beta

Rachel Fixsen looks at how a more sophisticated understanding of hedge fund risks is changing the way investors integrate these strategies into their portfolios

If pension fund school had a kindergarten, the first thing managers would be taught – once they were sitting cross-legged on the carpet – would be the benefits of diversification.

Spreading risk has always been fundamental to pensions investment, but the events of 2008 have focused minds even more sharply on the need to do so. The financial crisis and market crash that devastated investment portfolios across asset classes sent many pension funds looking to hedge funds, whose alpha-based strategies promise diversification by achieving returns that are uncorrelated with broader markets. But the crisis also prompted investors to look at these strategies with a much more critical eye.

Guy Saintfiet, UK head of liquid alternatives at consultancy Aon Hewitt, says single-strategy hedge fund returns were down 15-20% in 2008, showing that the funds were not just delivering alpha but also relied on market beta and ‘alternative betas’ – sources of risk and return that go beyond simple market exposures but are still essentially systematic, like volatility or illiquidity.

“There have been a lot of misunderstandings about hedge funds,” he says. “Some thought they were an asset class and they certainly are not – they are a bunch of heterogenous strategies.”

Some people have been mistaking market returns within hedge funds for skill, and have been paying for that, he says. But in certain cases hedge fund returns are gained from alternative beta, with only a small part of their overall return derived from genuine skill.
“This is why as an investor, it is important to do the due diligence to do a proper analysis to see what drives the returns,” Saintfiet stresses.

The crisis of 2008 also taught institutional investors to consider their hedge fund exposure in more detail because of the liquidity problems that arose, according to Stephane Enguehard, head of fund of hedge funds development at Lyxor Asset Management.

“They learned that they prefer customised funds rather than going into a commingled vehicle, and secondly, to distinguish more between single hedge fund strategies and the benefits and the risks that each of them can bring in a portfolio,” he says.
Investors are now opening the hedge fund box to see what is really in there.

“Instead of lumping hedge fund returns together into an amorphous set of returns that are all considered to be alpha, people are more conscious of the types of returns they’re getting, and seeing them in the context of their overall portfolio,” says Ronen Israel, portfolio manager and principal at US-based investment firm AQR, which manages both hedge funds and traditional long-only strategies.

Attitudes among investors have gradually been changing over the last five years, Israel observes. “Investors have been responding to the fact that hedge funds were not exactly what they thought they were,” he says.

In some cases, hedge funds have exposures to traditional betas in their investments, such as long equities – sources of return which most agree have little place in hedge funds. But Israel also says that forms of alternative beta do have an important role within hedge funds, and are among the strategies the funds run that are classic in nature, uncorrelated with traditional markets but not classed as alpha. While such strategies might belong in hedge funds, the fees managers charge for them may be too high.

“Hedge funds have historically got away with lacking transparency, charging high fees and having unfriendly investor terms – as if everything they’re providing is pure alpha,” says Israel.

Justin Sheperd, portfolio manager and chief investment officer at Chicago-based fund of hedge funds manager Aurora Investment Management, also says beta has its part to play in hedge funds. Although it is possible to separate out the strategies into alpha and beta to a certain extent, wherever there is a good source of alpha there may be some beta, he says, and investors have to risk-manage around that.

Pension funds are certainly looking at hedge funds now as a more holistic part of their portfolio, he finds.

“There are a sill a lot of people who want the classic diversification benefits of hedge funds – orthogonal risk and a unique return stream compared to what’s already in their portfolio,” he says. Increasingly, however, he finds clients such as pension funds are asking for more tailored hedge fund exposure within their portfolios. “Markets are on a good run, but pension funds are frustrated by the volatility. They want strategies that are more alpha, but don’t want to create a dark line between beta and alpha.”

Sheperd does not see the losses suffered by pension funds in 2008 as evidence of their beta exposure, but as an unavoidable consequence of the nature of that particular crisis.

“This was an event that caused beta strategies to have a difficult time, and it also caused hedge funds to have a difficult time as risk premia blew out across the board,” he says.
“Hedge funds do have to take risk and, in 2008, any risky asset was under severe pressure, although one cannot discount the differential performance between equities and hedge funds, as hedge funds had approximately half the drawdown of equities in this period.”

Rather than scrutinising hedge funds by strategy, Jason Malinowski, Seattle-based head of fiduciary risk management at BlackRock Alternative Investors, believes it is more relevant for pension funds to consider the true underlying risk factors of a hedge fund and how it relates to the portfolio. Managers running a particular strategy simply cannot be thought of as a homogeneous group, he says. Taking global macro as an example, he notes that the term is often used to describe both discretionary macro strategies and trend-following managed futures, despite their clear differentiation.

“Another example is long/short equity; you have some managers who are running 70% net long,” he says. “They could be used to substitute pension funds’ traditional equity exposure.”

Looking at hedge fund strategies in terms of risk exposures or even underlying positions allows investors to fit hedge funds into their overall asset allocation, says Thomas Weber, managing partner at alternative investment manager LGT Capital Partners.

“Whereas hedge funds do have exposures to traditional risk factors like equity and credit factors, they also have skill risk and illiquidity risk,” he says. “We model those and other risks across traditional and various alternative asset classes  – hedge funds, private equity, insurance linked securities and so on – to achieve intelligent diversification and exposure to different return drivers.”

Consultancy Towers Watson believes hedge fund returns should be dissected into bulk or traditional betas, smart betas and different sources of alpha.

“There are many different ways to think about smart betas, but we think about them in three different categories – diversifying smart betas, systematic smart betas and thematic smart betas,” says Matthew Roberts, head of multi-strategy hedge fund research at Towers Watson.

Diversifying smart betas include insurance premia, systematic smart betas include trend-following strategies and thematic smart betas are return sources where there is a long-term macro-type theme, such as emerging markets currency, Roberts explains.

Value for money is part of the reason why it makes sense for a pension fund, for example, to separate out the return sources of hedge funds, he says. “Investors are more and more focused on paying the right price for what it is they’re receiving.”

It is easy to get access to the traditional betas at low cost, says Roberts. And although fees should perhaps be higher than that for some of the smart betas, they should not be as high as those normally charged by hedge funds.

Apart from the issue of limiting investment management fees, distinguishing between hedge fund return sources is also useful in order to create a more robust portfolio overall, he argues.

While traditional and alternative betas can be accessed at lower cost, Malinowski at BlackRock makes the point that a cheap commoditised alternative beta product does not necessarily offer investors as much value as similar exposure within a hedge fund.

“There have been hedge fund replication products for the last few years, but people have generally not been pleased with the performance of these products,” he observes. “This points to some of these non-traditional beta products not being attractive on their own: without an alpha proposition, they are potentially less interesting.”

Saintfiet says scrutinising hedge funds is all about identifying the managers that offer attractive risk reward and diversification benefits. “It does require a large group of experienced individuals and a robust research process to identify those managers that add value,” he says.

So how could investors use traditional hedge fund strategies to construct portfolios based on exposures to different categories of risk?

The best approaches for pure diversification are CTAs and insurance-linked securities (ILS), suggests Weber.

“CTAs are able to diversify equity and other risks in crisis situations – in 2008, for example, and more recently in May 2012 – and they can tactically and quickly reverse market positions from long to short and back, which is important in risk-on, risk-off environments,” he says.

ILS diversifies because it is an asset class driven by natural phenomena like earthquakes and hurricanes, rather than financial markets.

For Malinowski, market neutral, macro, managed futures as well as fixed income arbitrage can all offer significant diversification to portfolios.

Within a portfolio aiming to provide exposure to illiquid assets, Sheperd believes distressed credit strategies would fit well, as well as activist strategies where, although the securities themselves might be liquid, the assets often must be held for a period because of the time required for the activist process. Malinowski adds that newly emerging sectors such as direct lending and energy finance would similarly fit well in an illiquidity portfolio.

And what if the objective is not so much diversification against a traditional asset portfolio, but rather the enhancement of the risk-return profile of those traditional asset exposures? Where investors are looking for enhancers of traditional beta in their portfolio construction, Sheperd says certain hedge fund strategies could be grouped together, such as equity long-short and credit long-short.

Enguehard notes that while it makes sense intellectually for investors to include hedge fund strategies that have residual beta, such as long-short equity and long-short credit, in their long-only equity and credit portfolios rather than group them with pure alpha hedge fund strategies, in fact investors rarely do this.

“This is because the way investors approach their long-only equity and credit investments is through benchmarking,” he says. Hedge fund investing does not use benchmarks, so the categorisation of these vehicles does not fit in a pension fund’s overall equity and credit portfolios, he explains.

In this case, then, it is precisely the absence – or rather, the unpredictability – of traditional market beta that is the problem.

As institutional investors gain a better understanding of the underlying risks driving hedge fund returns, and as they deepen their relationships with those hedge fund managers and begin to tailor the deployment of the industry’s skillset to their own, pre-defined objectives, the way those strategies fit into portfolios could change quite profoundly. We are still at an early stage of that evolution,and some investors are at a much more advanced point than most – but the fundamental building blocks of this new approach are very much in pace.

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