Hedge Habits to Leave Behind in 2018

Hedge Habits to Leave Behind in 2018

By Diane Harrison

Before setting resolutions for 2019, December provides managers and investors with a good time to break bad habits endemic to the hedge fund community. There’s no shortage of subjects where these practices lurk, but here are five suggestions on habits to leave behind in 2018.

ONE: DON’T BURY THE LEAD OF THE ALTERNATIVES STORY

I have heard numerous times from alternative managers and their sales support that one of the challenges hardest to overcome in reaching out to prospects is communicating the role of alternatives within a portfolio plan. Because investors typically find the instruments used in many alternative strategies, namely debt and equity components, more familiar to them, the conversation turns to discussing particular segments of the debt or equity markets used by the alternative strategy rather than how the strategy performs itself.

The CFA Institute Research Foundation summarized this issue in their 2018 paper, Alternative Investments: A Primer For Investment Professionals (Donald R. Chambers, CAIA, Keith H. Black, CFA, CAIA and Nelson J. Lacey, CFA}: Alternative investments include strategies that offer unusual risk and return characteristics even when the securities underlying the strategy are traditional stocks and bonds. The returns of alternative investments do not mimic the returns of traditional asset classes (stocks and bonds), and therefore, they require specialized methods of analysis. The challenge for an asset allocator is to decide, as skillfully as possible, which new types of assets to include in a portfolio and which to exclude.

Due in part to this, a challenge for providers of alternative strategies is to assist investors in a better understanding of how a nontraditional alternative strategy works, how that impacts the traditional components of a portfolio, and how best to integrate the two asset classes.

TWO: DON’T SHY AWAY FROM THE ‘R’ WORD—EMBRACE THE SUBJECT OF RISK AS AN ASSET

Another touchy subject for alternative sales professionals is the topic of risk. Alternative assets often carry higher risk then traditional assets, but this is not necessarily a bad thing. There is a bias against emphasizing risk with equal weighting to return, yet the relationship between the two is central to assessing the value of any strategy, alternative or no. Many alternative investment strategies have been constructed to take advantage of a higher band of risk in search of greater return potential, and these strategies can work together with more moderate components of a portfolio to provide an overall enhanced result to investors.

Ronald N. Kahn authored a paper, The Future of Investment Management, for The CFA Institute Research Foundation this year that states: Investment management is an inherently uncertain activity. Risk—the distribution of potential outcomes—is unavoidable. But the approach to this uncertain activity is increasingly systematic. Indexing and smart beta/factor investing are both very systematic. Pure alpha investing has become increasingly systematic as the understanding has grown for the magnitude of the challenge. Sustainable investing is often quite systematic.

One productive approach in discussing risk with prospective alternative investors is to educate them on the value of quantifiable risk, downside protection, risk controls, and the like when presenting an alternative strategy focus as a potential value add. The overall subject of disciplined, systematic approaches with repeatable demonstrated results can work wonders to alleviate an investor’s negative bias toward strategies with relatively high risk profiles.

THREE: DON’T MINIMIZE THE INHERENT OPACITY OF ALTERNATIVES

Another common complaint registered by investors about alternative products is the difficulty of obtaining full transparency about the investment construction, how it’s doing, and how it impacts the rest of a portfolio. Great strides have been made by the industry over past years with regard to this issue, with both regulatory and industry improvements working together to ensure more complete, timely, and relevant information provided to investors both large and small.

Despite the progress being made in industry communication, investors and their advisors share a responsibility to increase their knowledge and understanding of alternative investments. The sales effort for alternatives should address this dual effort for both providers and participants working towards a fuller understanding of how these products can and should perform.

The CFA Institute Research Foundation paper, Alternative Investments: A Primer For Investment Professionals, mentioned earlier also states: Alternative assets are often less regulated, more complex, and private (than traditional investments). As a result, overseers of alternative assets often need to be familiar with such issues as:

  • safekeeping of assets
  • pricing and settlements
  • technology
  • reporting and compliance
  • familiarity with necessary investment parameters for derivatives, such as the International Swaps and Derivatives Association (ISDA) Master Agreement, a service agreement for OTC derivatives that sets the terms for both sides of the contract
  • third-party service providers, and their function in overall administration and compliance issues.

FOUR: STOP TOUTING THE 2008 MARKET CRASH FEAR-MONGERING TALE

The alternative investment industry is not as nascent as it once was: indeed, there are decades of performance in which individual investors have participated alongside their institutional brethren. We are now almost eleven years beyond the 2008 marker in volatility, and hedge fund managers have grown over reliant on using the episode to sell their alternative strategy.

The continued exploitation of investor fears— which spared few among the high net worth, pension and endowment funds, as well as institutions—works against an effective education message centered on long-term, full-cycle market investment in alternatives. Better to replace the scary 2008 crash scenario with thoughtful, balanced time horizons of alternative investment holdings that define a long-view investment attitude through up, down, and sideways market cycles.

FIVE: RESULTS: DON’T OVERPROMISE, THEN UNDERDELIVER

Since 2008, global sustained quantitative easing, with its historically low interest rates spurring quantitative and passive investing, created a difficult environment for many alternative managers to make money. With a massive underperformance record versus stocks, hedge funds on average have found themselves subject to valid criticism about not living up to their performance promises.

This issue sparked a widespread call for reduced fees in alternative products over the past several years, as investors rejected the traditional 2%/20% model on the heels of sustained underperformance. Managers of all sizes were forced to shave their costs, reduce management fees, and increase fund liquidity in an effort to keep existing investors as well as attract new participants. There was a positive side to this fee reduction: marginal funds were forced to close, operating costs were closely scrutinized for efficiency and effectiveness, and third party providers across all manner of operational support were galvanized into existence. With outsourced support gaining favor from managers and investors for better transparency, compliance and reporting, managers can rededicate their internal focus on the business of investment strategy and differentiation, the core of their value, and accurately showcasing this ability.

 Diane Harrison is principal and owner of Panegyric Marketing, a strategic marketing communications firm founded in 2002 specializing in alternative assets.  She has over 25 years’ of expertise in hedge fund and private equity marketing, investor relations, articles, white papers, blog posts, and other thought leadership deliverables.

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