By Appomattox Advisory, Inc.
The discussion has revived again: are hedge funds still relevant in a diversified portfolio?
We believe that a thoughtful allocation to hedge funds continues to be an impactful, prudent and profitable strategy for institutional portfolios.
For allocators seeking to achieve stable returns in a difficult investing environment, hedge funds play a vital role. A successful hedge fund allocation protects capital while generating alpha, thus improving the risk/return profile of an overall portfolio. However, the key to achieving this objective is manager selection.
At Appomattox, fund managers must meet Four Fundamental Criteria for inclusion in our portfolios:
- Alpha from active management
- Downside protection
- Less correlated returns
- Aligned interests
The recent negative press around hedge funds has focused primarily on high fees in light of mediocre returns. Many of the headline hedge fund names being discussed are the largest and most well-known in the industry. They are funds that fit the requirements of the institutional investment process but have failed to perform. However, the +10,000 hedge fund universe consists mostly of smaller hedge funds, not large funds (with assets in excess of $1billion). While large funds represent approximately 80% of assets under management and count large institutions among their investors, it is often the smaller, emerging firms that meet our Four Fundamental Criteria. Furthermore, investing early in a fund’s lifecycle creates a series of additional advantages to investors, including increased transparency, manager access, decreased fees and typically higher returns.
Four Fundamental Criteria for Manager Selection
- Alpha from Active Management: Hedge funds are the most actively managed funds; they seek return from multiple alpha sources. Smaller, more nimble funds are frequently better suited to capturing higher alpha, especially in the current less liquid market environment. Ultimately, one is paying for active management to outperform a passive strategy. Understanding a manager’s value-add under all market conditions requires both good measurement tools and an experienced team to interpret the information.
- Downside Protection: Managing drawdowns and minimizing downside volatility leads to outperformance over a market cycle. A manager’s ability to hedge, or protect capital, is part of what investors pay for. Hedge funds are supposed to protect capital. Managing risk, reducing downside volatility, and limiting drawdowns are components of what all hedge funds are expected to incorporate into their portfolio construction process.
- Less Correlated Returns: The expectation with hedge funds is that they generate returns that are not highly correlated with traditional assets. Hence, they need to be evaluated in both up and down markets. Regardless of the source of reduced correlation, this feature of hedge fund strategies should improve a portfolio’s overall risk-adjusted returns.
- Aligned Interests: Managers are best positioned to deliver on all these expectations when they are motivated to generate returns for the investor: when they have meaningful “skin in the game”. Attitude matters. Smaller and emerging managers grow based both on their performance and client satisfaction. The basis for strong alignment of interests exists if fee arrangements are constructed to incentivize performance rather than asset gathering.
Avoid the Creep of Mediocrity
Managers must meet all Four Fundamental Criteria in order to provide value to the investor and justify their fees. If not, we disinvest. Finding managers that meet all Four Fundamental Criteria takes experience and skill. As the dispersion among hedge fund managers is substantial, the focus must be on identifying superior managers, not just average performers. Often, talented smaller and emerging managers will satisfy all criteria, but they are overlooked as they do not have the institutional profile that lends itself to investing by larger institutional players.
Maximizing the Benefit of Hedge Funds in a Portfolio
A sizable and thoughtfully selected hedge fund allocation, guided by the client’s portfolio objectives and constraints, is necessary to positively impact a portfolio’s risk and return profile. A well-chosen allocation to hedge fund managers based on the Four Fundamental Criteria can help allocators achieve these goals for their portfolios.
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