Widening investment horizons
Institutional and individual investors are increasing allocations to alternative asset classes and, in particular, to hedge funds, says Citibank Alternative Investment Strategies
Hedge funds are one of the fastest growing investment alternatives to traditional equity and bond portfolios. Today there are roughly 3,000 hedge funds worldwide, which collectively manage almost $400bn in assets.
Although wealthy individuals were traditionally the main investors in hedge funds, in recent years institutional investors such as pension funds and endowments have been a growing presence in the hedge fund industry. Greater interest by institutional investors has created a larger asset base for the hedge fund industry and has pushed hedge fund advisors to improve the level of transparency. This article aims to further increase investors’ understanding of the benefits of hedge funds and their role in investment portfolios.
In many ways, hedge funds, accessed individually or via multi-advisor funds, are generally more diversified and provide greater transparency than private equity, offer increased liquidity, and can be marked to market on a daily basis. In their multi-advisor forms, hedge funds can be structured by the manager to exhibit a wide range of risk and reward characteristics (Figure 2). Among investors seeking customised solutions, this flexibility can be a crucial consideration.
Hedge funds, in general, use a variety of investment techniques, asset classes, and strategies that are not available to traditional stock and bond managers to deliver the major benefits associated with alternative asset classes:
q The ability to improve portfolio diversification and smooth out returns via low or negative correlation to traditional asset classes. In Figure 3, note the marked contrast between the five worst weeks in the US equity and bond markets in recent years, versus the five worst weeks of a multi-advisor hedge fund. Since hedge fund strategies tend to be uncorrelated with equity and bond markets, the inclusion of hedge funds can potentially reduce the risk of a traditional portfolio.
q Access to a wide array of markets and trading strategies within an environment that emphasises risk management. Quantitative risk management methodologies enable the
managers of hedge funds to evaluate and monitor an increasingly wide array of trading strategies, such as market neutral and long/short strategies (Figure 4).
q Opportunities for higher returns per unit of risk. Adding a hedge fund to a traditional equity and bond portfolio can increase aggregate return while lowering volatility. The Sharpe Ratio is the common tool used to measure risk-adjusted returns (target return less the risk free rate, divided by the standard deviation). The risk/return trade-off shown in Figure 1 reflects the addition of the HFR Fund of Funds Index to a mix of global securities. As you add hedge funds to the asset mix, the Sharpe Ratio improves continually as more of the portfolio is allocated to hedge fund strategies.
q Portfolios tailored to risk/return expectations. Hedge fund strategies can be structured to provide investors with a more extensive range of income, growth, and risk attributes than are available solely with traditional investments. For example, as discussed later in this article, hedge funds can be designed with a principal guarantee for those investors most concerned with capital preservation.
Although hedge funds do offer specific benefits, the level of benefit may depend on whether the hedge fund is a single-advisor hedge fund, a multi-advisor hedge fund, or a fund of funds and the degree of active management employed (Figure 5).
Single-advisor versus multi-advisor hedge funds. Single- and multi-advisor funds can be distinguished by the degree of diversification achieved, their capacity for investment, and degree of risk management employed.
q Diversification. Because a multi-advisor hedge fund can employ multiple strategies across numerous markets, it offers a higher degree of diversification – and correspondingly lower volatility – than a single-advisor hedge fund, which generally employs only one strategy. Additionally, the multi-advisor fund not only diversifies between strategies but also between advisors whose returns exhibit low or non-correlation to one another.
q Risk/return trade-off. A single-advisor hedge fund has the ability to outperform a multi-advisor hedge fund due to its highly concentrated strategy. However, carefully constructed and actively managed multi-advisor funds can both lower manager-specific volatility and deliver competitive returns over extended periods of time. Again, consider the risk/return graph. A multi-advisor fund has the ability to choose the “best” advisors (in the HFR Fund of Funds universe, for example) within each trading style. By carefully combining trading advisors, a multi-advisor hedge fund has the potential to outperform a single advisor hedge fund while reducing manager-specific risk.
q Risk monitoring. Multi-advisor hedge funds are overseen by a trading manager whose mandate is to objectively reduce the allocations toward trading strategies that are under-performing or less promising, and to direct assets toward strategies that may have more potential. Single-advisor funds must rely on one individual or team to evaluate its strategies, without the recourse of diverting assets to more successful strategies employed by other advisors.
q Investment capacity. A single-advisor fund will close to new investment once it has reached capacity. In contrast, a multi-advisor fund can accommodate additional participation via an allocation to another advisor with a similar strategy and return pattern.
Multi-advisor hedge funds versus fund of funds. Multi-advisor hedge funds, which may also invest through separate accounts, have several advantages when compared to most fund of funds:
q Risk monitoring. A key advantage is the trading manager’s ability to review each trade executed by the advisor on a daily basis. This allows the manager to monitor the portfolio’s risk exposure at all times. In a fund of funds, the trading manager reviews performance on an aggregate basis only, which restricts his ability to monitor daily risk exposure.
q Manager selection/termination. The multi-advisor fund trading manager negotiates investment guidelines with each trading advisor to determine position limits, stop-losses, and leverage. By monitoring the fund against these on a daily basis, the trading manager can take decisive action to terminate an advisor who has breached a guideline, potentially reducing the possibility of additional losses to the portfolio.
q Fees and investment capacity. The trading manager in a multi-advisor fund negotiates investment advisory agreements that determine fee arrangements and capacity requirements with each advisor. Thus, a multi-advisor fund may offer both a lower fee structure and greater capacity to investors than a fund of funds.
How a trading manager selects and combines advisors and allocates assets can substantially differentiate one multi-advisor fund from another. Plan sponsors, and other institutional and individual investors, performing due diligence on multi-advisor hedge funds should consider the following key factors:
q Trading manager investment philosophy and approach. The most passive trading managers use either an equal weighting asset allocation approach or a simple mean variance optimisation system. A small number of trading managers employ a more active process: conducting extensive bottom-up research to identify attractive trading advisors; constructing portfolios around investor expectations for risk and return, and correlations over the investment horizon; and systematically rebalancing multi-advisor hedge fund portfolios to make tactical shifts as conditions change.
q Cash management. How actively and efficiently the trading manager manages cash is an important factor in multi-advisor funds where a portion of the sub-advisors may trade on margin.
q Risk management expertise. The fund should possess the systems and staff to review P&L reports for each advisor on a daily basis and to perform ongoing quantitative monitoring.
The ability of most multi-advisor hedge funds to conduct quantitative analysis is comparable; however a multi-advisor fund’s ability and commitment to regularly review qualitative factors such as the quality of a sub-advisor’s investment professionals, the commitment of key personnel, regulatory issues, and adherence to fundamental guidelines can be an important point of differentiation. With numerous sub-advisors to monitor, qualitative analysis can be a time-consuming and staff-intensive process that not all multi-advisor funds can readily support.
q Asset allocation process. Investors should ask how the manager accesses asset allocation-related information; how this information is analysed; how these analyses are applied to asset allocation decisions; and the frequency with which asset allocation refinements are implemented.
q Identification of talented trading advisors. Trading managers must still perform rigorous due diligence when selecting advisors and continue to seek new candidates outside their existing pipelines. However, the investor can benefit when the manager has access to a large universe of well-known managers in addition to relatively unknown managers who have created new technologies and techniques to exploit inefficient market segments. In recent years, the competition for the most attractive fund managers has grown more intense, and a line of demarcation has evolved between those multi-advisor hedge funds that can attract a wide spectrum of innovative traders, and those funds whose access to the most sought-after talent is less commanding. The tendency of the widest pool of talent to gravitate to certain multi-advisor hedge funds has grown more pronounced.
Multi-advisor hedge funds that accommodate capital protection strategies attract investors who desire the low correlation to traditional assets afforded by hedge funds, but may also require a certain level of principal stability.
Protecting principal. In general, there are three basic approaches to providing principal protection to multi-advisor hedge funds. The overall performance under these approaches will depend on the interest rate environment, the fund’s performance, and return volatility during the investment period.
Passive approach. This approach allocates the initial investment between high-quality zero coupon bonds and a fixed hedge fund investment. Here the allocation to the zero coupon bond investment is designed to grow to 100% of the initial capital investment providing the principal protection while the active fund investment would generate the total return on the initial amount invested. In adverse conditions even if the hedge fund loses money, the investor will receive his initial capital invested (Figure 7).
Dynamic approach. This type of principal protection programme is generally offered by a financial institution (bank/insurance company) in the form of a “guarantee” or a “letter of credit” which assures the investor of their principal return (“guaranteed amount”). The letter of credit promises to pay the investor the difference between the guaranteed amount and the net asset value (NAV) of the fund at a fixed date in the future. The guarantee provider manages the risk of trading losses through a dynamic risk management process.
This dynamic function controls the trading activities of the fund portfolio as follows (Figure 8):
q When the fund performs well, it leverages the fund by allocating more assets to the active fund investment to take advantage of favourable market conditions.
q When the fund performance is poor or the market enters a downtrend, it deleverages the fund by allocating fewer assets to the active fund investment to reduce the fund’s exposure.
Derivative approach. More recently, principal protection programmes are being developed utilising derivative structures. For example, a derivatives house will sell call options on fund shares. These call options are further packaged with a high quality zero coupon bond investment to secure principal protection and to achieve an upside participation in the hedge fund performance through the call option payoff.
Leverage. For investors seeking even higher returns than the fund’s trading strategies can offer, external leveraging can be employed. Leveraging is a benefit for the investor as the trading advisors can trade over 100% of the investor’s assets, potentially offering far greater (or far lower) returns. Leveraging a hedge fund involves borrowing from a third-party lender under standard margin agreements. In general, a greater degree of external leverage against the fund can be obtained when the fund exhibits low volatility and low drawdowns. These attributes make the fund a more stable vehicle for leveraging.
Hedge funds are growing dramatically with some of the finest investment talent shifting to this style which can offer both diversification and competitive absolute returns in difficult market environments.
Multi-advisor funds allow institutions access to this growing investment talent pool. Within an actively managed multi-advisor fund, the trading manager conducts due diligence, provides risk monitoring, implements portfolio rebalancing and makes tactical asset allocation decisions as market conditions change, negotiates fee and brokerage arrangements, replaces underperforming trading advisors, and adds capacity as talented managers close to new investors.
This article is based on ‘Multi-Advisor Hedge Funds’, published by Citibank Alternative Investment Strategies