Some investors consider hedge funds mysterious, aggressively managed investments, too risky for the typical portfolio. Sceptics may be surprised to learn that most hedge fund managers focus on providing capital appreciation with lower volatility than the broad markets.
A “hedge” is defined as a fence or boundary, and an object intended to restrict something — such as portfolio risk.
Despite the misconceptions, the popularity of hedge funds continues to grow, with assets rising from $38 billion (Dh139.5 billion) in 1990 to $2.8 trillion (Dh10.3 trillion) in 2015, representing a significant change in asset allocation, perhaps the most meaningful shift since investors moved from bonds to stocks in the 1980s.
It is not only institutional investors shifting assets to hedge strategies; individual investors are also moving into the space. The advent of liquid alternatives fund structures, which offer hedge strategies through a mutual fund vehicle, has helped drive this shift. These structures provide wider access to hedge strategies, and can offer potential benefits in terms of liquidity, fees and transparency.
Generally, traditional access to hedge funds via private placement vehicles often meant less liquidity, with redemption periods restricted to monthly or quarterly windows. In addition, visibility into portfolio holdings (transparency) was limited. Liquid alternatives by contrast offer daily liquidity, security-level transparency and fees that are typically lower than those associated with traditional hedge fund vehicles.
Intensified interest
Unlike hedge funds, liquid alternative portfolios must generally adhere to the same regulatory requirements as conventional mutual funds, sharing information that private placements are not required to disclose.
Recently, interest in hedge strategies has intensified. This is because investors are facing a dilemma. They are searching for yield but interest rates from fixed income products have generally been low, and there is fear that equity markets could be nearing a period of intensified volatility. In addition, many investors are looking for greater diversification in their portfolios. Using non-correlated strategies within a portfolio can help smooth out the ride when one particular asset class or strategy may be experiencing a volatile period. Additionally, hedge strategy managers can take short positions that benefit from market declines, cushioning a traditional long-only portfolio.
Four common strategies used by hedge fund managers include: long-short equity, relative value, event driven and global macro.
Long-short equity
When employing the long-short equity strategy, hedge fund managers take a long position in a stock they think will outperform, while shorting stock that they believe will underperform.
Within the long-short equity strategy, there are generalists, geographic and sector. The long-short equity strategy generally has performed well in flat to rising equity markets that are driven by corporate fundamentals.
Relative value
The relative value strategy encompasses a wide range of investment techniques that focus on pricing inefficiencies between two similar securities. Hedge fund managers occasionally use convertible bonds to deploy this strategy. Convertible bonds, which are bonds that may be exchanged for a specific amount of a company’s stock at a future date, may be priced inefficiently compared with the value of a company’s stock or its straight bonds. All things being equal (if, in other words, the coupons are the same), if the durations are the same, a convertible should be priced at a premium to straight debt because there is, presumably, value in the potential for the underlying equity option embedded in the convertible.
The relative value strategy generally has performed well during periods of equity market uncertainty and in flat to rising bond markets
Event driven
Event-driven managers invest in securities of companies in the midst of corporate events such as bankruptcies, changes in capital structure, or mergers and acquisitions.
The trade would occur after the announcement, not because the managers were speculating on rumour. The key risk of such a position is a deal falling apart. Event-driven strategies tend to have performed best when markets have rallied, but also may work when corporate activity is high.
Global macro
Global macro strategies focus on top-down macroeconomic opportunities with numerous markets and numerous investments, including currencies and commodities. When considering their investment choices, global macro managers take into account many factors, which may include a country’s or region’s economic indicators and central bank trends and divergences.
Global macro may be used in conjunction with the three other strategies we’ve covered, and it generally has performed well in periods when markets have marked trends, either up or down.
Multi-manager approach
While the strategies employed by hedge fund managers are diverse, traditional hedge funds typically offer a single manager and a single strategy. Many liquid alternatives funds are multi-strategy funds that invest in different managers within the same strategy, or different managers within different strategies.
A multi-strategy approach strives to provide a constructive level of diversification within a portfolio. Further diversification through selecting multiple managers within each strategy may help mitigate manager-specific risks. Managers can have varying styles or approaches within the same hedge strategy, possessing expertise within a certain area. Among the various types of hedge strategies, each may perform differently in a given market environment.
It is key to have experienced professionals tilt toward strategies that have the largest potential opportunity set for returns in a current market environment and in the forward-looking market environment.
The writer is a founding managing director at K2 advisers, Franklin Templeton Solutions.
