|02 July 2012||Tweet|
|Transitioning to direct investment in hedge funds|
The times are a-changing in the hedge fund world. There was a time when investors took their first steps into this esoteric world via the fund of hedge funds route. Following disappointing performance in 2008, investors have been wondering whether funds of hedge funds are worth their fees when direct hedge fund investment can provide lower fees, better diversification and a more targeted use of one's risk budget.
But where to invest when there is such a bewildering range of hedge fund strategies, with widely varying risk/return and market exposures, not all of which are necessarily good diversifiers or generators of alpha. Contrary to common perception, hedge funds are not an asset class, but a disparate collection of active trading and investment strategies whose objective is to produce absolute returns, irrespective of market conditions.
Despite the multitude of hedge fund strategies, the bulk of them fall within four main areas: equity long/short, relative value, event driven and trading, whose principal characteristics are set out below.
As its name suggests, equity long/short requires the manager to buy undervalued equities and short overvalued ones. Because it is easy to understand, this strategy is often the first step for those moving to direct hedge fund investment. But there is often a considerable amount of equity beta in this strategy. There is even the threat of beta when there is an equity market neutral approach because in a time of equity market crashes, betas change sharply. Long/short strategies can have subtle biases such as value versus growth, mid cap versus large cap. On the upside, long/short strategies are relatively transparent and the risks (from shorting) are obvious, albeit potentially considerable. Due to its potential for beta and equity market exposure, equity long/short is not such an effective portfolio diversifier as some other hedge fund strategies, although it can be a very effective equity return enhancer.
Event driven strategies aim to generate returns from market inefficiencies surrounding corporate events such as mergers and acquisitions, or defaults. Examples of drivers of return are the deal premium, the deal flow in mergers, the default rate, the discount to fair value in distressed debt and the liquidity premium. The downside is that the portfolio can become quite correlated with equity and credit markets in adverse conditions and also can experience illiquidity problems. As a result, event driven strategies are not the best diversifiers in shocked or panicky markets, although they can enhance and diversify portfolio returns in quieter times.
Relative value strategies aim to generate returns from spreads or pricing discrepancies between similar instruments in the same or similar markets, such as short term inefficiencies generated from supply/demand mismatches. Pure arbitrage strategies are nowadays either non-existent or dependent on very high levels of leverage so although relative value strategies are sometimes referred to as ‘arbitrage’, they offer neither instantaneous, nor risk-free profits.
The main risks in the strategies are that positions become decoupled and the link between long and short legs of a trade can become less alike and so less implicitly linked. Relative value strategies can provide good diversification due to their lack of dependence of market direction. However, risks in such strategies tend to be insidious and not identifiable from studying the volatility of track record alone.
Trading strategies include everything from quantitative investing and trend following to discretionary trading and global macro driven investment. Returns are dependent on manager skill in the latter case and on technological and scientific expertise in the former.
Quantitatively driven trend following strategies have an implicitly long volatility return structure and so make good diversifiers in large market swings.
Although trading strategies such as CTAs and global macro are generally good diversifiers, there is always the risk that they could end up on the wrong side of equity or credit markets when they crash. It can also be difficult to identify the reason for periods of underperformance. Otherwise, there are few hidden risks.
Routes to accessing hedge funds
Having summarised the four main types of hedge fund strategies, it is clear that some types of hedge fund generate returns that partly derive from the direction of underlying markets. So given the expense, it makes sense to restrict one's hedge fund investments to areas where a similar return cannot be achieved elsewhere if pure diversification is needed. However, the full range of hedge fund strategies can benefit a broader portfolio if investment is aimed at return enhancement.
Many investors, who have been disappointed by the cost and poor performance of funds of hedge funds, are now considering a move to direct investment. Yet moving wholesale from one to the other is perhaps difficult for many of these investors.
bfinance recommends a gradual transition or hybrid approach whereby investors maintain the core of their fund of hedge fund investments and institute a small number of satellite positions in effective diversifiers. Typically, diversifying hedge fund strategies tend to be at the more liquid end of the hedge fund universe so that should the switch not be successful, it can easily be unwound.
Complementing a portfolio with targeted direct hedge fund investment enables better risk budget management , the potential for lower fee negotiation, transparency in the selection process and the underlying portfolio, better diversification, ownership of the assets and currency management.
The downside is that hedge fund strategies have greater complexity than traditional investments and may require outsourced advice and more involved and frequent monitoring.
Hedge funds have matured since their inception and are now considerably more approachable for direct investment. bfinance recommends that for hedge fund mandates worth up to $50m, investors should continue to invest in fund of hedge funds, but for mandates of $50m-200m, investors could consider investing in a combination of single manager hedge funds and fund of hedge funds. For mandates worth more than $200m, bfinance believes that investors should consider investment in single manager hedge funds only, advised either by a fund of hedge fund manager or a consultant.
Factors influencing such a transition would include the required level of control delegation, fee level tolerance, the number of investments involved and available resources for monitoring.
In summary, moving from fund of hedge funds to direct investment is a big step. But by taking some capital from your fund of hedge fund investments and applying it to the most diversifying strategies such as trading (macro and CTA), an investor can plug gaps in his existing portfolio while keeping options open if things go wrong. By measuring the impact of direct investment on the broader portfolio, rather than in terms of standalone track record, asset owners will be able to gauge the complementary and diversifying benefits of direct investment.