Is Hedge Fund Popularity Waning?
Value for money and disappointing performance versus passive market indices are often touted amongst the primary reasons for investors’ seeming aversion to hedge funds. Over recent years we have observed multiple institutional investors – Texas Teachers and CalPERS among them – bring their sizeable hedge fund allocations under review, catalysing a much broader reassessment of the asset class’s place in pension portfolios.
After a long bull market (currently in its 10th year) it is only natural for diversifying strategies to come under increased scrutiny. As a result, many investors have, logically, questioned the value of allocating to active strategies over cheaper passive options. Historical performance is often the key consideration in asset allocation decisions, in many cases prioritised over consideration of the risk taken to achieve it.
However, following the recent history of strong market performance, we believe that the decision to cut diversifying strategies is a dangerous one. Calm markets can build a false sense of security but diversification must always remain a core focus of any robust portfolio.
Investors thinking about hedge fund allocations should avoid too much focus on the label ‘Hedge Fund’. The term is very broad and covers a wide variety of strategies, albeit underpinned by a flexible and active approach adopted by the manager. Some multi-asset ‘Diversified Growth Funds (DGFs)’ have similar traits and could easily be included within the same bracket.
Considering how broad the hedge fund bracket is, a more appropriate question could be: “What is the purpose of these strategies in my portfolio?” Costs are important, but schemes’ assessment must extend beyond this factor alone and consider whether the strategy will enhance portfolio returns after fees, diversify risk or achieve both. Pension funds need to think holistically about return objectives and the risks they are able to take in order to achieve them.
As with any investment decision, schemes must consider how return expectations for traditional assets may vary over the course of the economic cycle. Those with a more cautious outlook for the future might need to consider a broader set of options for achieving return objectives and should question how hedge funds might fit in. If a portfolio already has significant traditional asset exposure and the strategy under review also tends to have high market exposure, this clearly offers limited differentiation. Regardless of the label on a strategy, overpaying and increasing complexity for something that is indistinguishable from a cheaper, simpler alternative makes little sense.
The same logical decision-making should be applied to other ‘hedge fund’ strategies, which can sit at the higher end of the cost spectrum. Value for money is a crucial part of the evaluation process. Yet, when it comes to any flexible active strategy, the most important consideration must be manager selection and the ability to identify skilled managers, able to produce active outperformance over and above the fees paid. The CMA’s review clearly challenged the notion that many investment consultants are capable of producing these results.
After assessing manager selection capability, the next question should be the extent to which manager incentivisation is aligned with portfolio objectives. In some scenarios, there can be creative ways for investors to improve the alignment/value proposition. For example, a stock picking hedge fund that seems to offer some valuable diversification but looks expensive, especially as it tends to have some structural long equity market exposure (not valuable!); an adjustment of fees in relation to outperforming an equity market hurdle, the value proposition could look more interesting.
Measuring value added for active strategies (including hedge funds) relies on a robust and transparent framework that also considers diversification potential. At Cardano, we believe that a careful selection of such strategies can play a useful role in well-diversified portfolios.