By Niki Natarajan
The secret to sustainable hedge fund investing is out. The principle is simple, so why are only a few awake enough to put it into practice? And what exactly is this secret?
Put simply, hedge funds are not an asset class but an active asset management tool. They cannot be expected to perform a miracle if they are lumped en masse in the corner of a portfolio.
This was underlined in this month’s edition by Jan Soerensen, PGGM’s head of hedge funds. PGGM has never seen hedge funds as an asset class, but the Dutch fund now no longer sees them as an isolated island supposed to generate return. “We want to optimise the return stream coming out of hedge funds to complement other parts of our portfolio,” says Soerensen (for story, click here).
The idea that hedge funds are an asset class was a gross oversimplification propagated in the early years to get institutional investors comfortable with hedge fund investing, Rick Sopher, head of LCH Investments, said recently.
The evolution of hedge fund investing over the past decade has been a little bit like playing with Lego. The first couple of boxes come with instructions that are copied assiduously. Over time, the Lego enthusiast glides effortlessly into creativity, putting the bricks together to build different structures.
It is at this point of subconscious competence – also known as mastery – that the manuals become redundant and the enlightened investor sorts hedge funds into strategy specific piles and allocates them into the parts of the portfolio that match in terms of asset classes.
Equity long/short with equities, credit strategies in the fixed-income buckets and those truly uncorrelated strategies like the commodity trading advisors – the non-brick components of Lego such as wheels and tiles – get put into the alternative bucket. For this asset-allocation reason, Dexion Capital has restructured the Dexion Alternative Equity Fund from a multi-strategy product to a concentrated long/short equity fund (for story, click here).
Not only will more money flow into hedge funds but the true protective power of this tool will really be seen. The idea of hedge funds as a tool was a common theme throughout the recent InvestHedge Forum (for report, click here, as investors discussed sustainability of performance.
LCH Investments, the oldest FoHF, has known this secret since inception (its three funds of funds are strategy-specific). But like the Buddhist proverb – ‘When the pupil is ready to learn, the teacher will appear’ – few have really understood how to use this type of strategy-specific product properly.
The reason the time is now right for investors to learn how to play with hedge funds correctly is that the world has been plunged into deep long-term uncertainty. With volatility and government policies threatening to turn markets upside down, portfolio protection has never been more important.
As Morten Spenner, chief executive officer of International Asset Management, said recently: “Hedge funds are now back doing exactly what investors expect of them.” That is, a complementary skillset that dampens volatility in tough times and generates consistent returns.
Despite the lacklustre numbers posted by hedge funds, they have protected portfolios when markets have hit turbulence. It is a myth, however, that all hedge fund strategies are uncorrelated all the time, but what is now being seen is that, used correctly, they significantly dampen volatility.
For equity investing, one only needs to look at the consistent performance of Barlow Partners since inception compared to the S&P 500 (for story, click here). To support the equity investing argument further, LCH’s annual research, which showed that of the total $557 billion in profits made since inception by hedge funds, 58.2% has been made in the equity markets (for story, click here).
But hedge fund investing is not about whether or not equities are better than bonds, as Diversified Global Asset Management has proven. DGAM does not invest in long/short equities at all. Its secret is not about which strategy or asset class, it is about tail hedging across the whole portfolio, a strategy which in August earned 124% (for story, click here).
What is key now is making sure all hedge funds are not treated like mushrooms and lumped in a dark damp corner of portfolios; otherwise, it will be like driving a Ferrari at 10 miles an hour.