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Liquid alts – Building a pandemic proof portfolio
The 2010s was somewhat of a torrid time for the hedge fund sector, as the pressure for lower costs and more transparency collided with a period of weaker returns. Institutional research consultant bfinance this week published a white paper, titled “How to build a hedge fund portfolio,” that offers some unique institutional insights for the advisory industry.
According to its analysis, hedge fund sentiment has turned decidedly more positive among asset owners, pension and sovereign funds in recent years. These professional investors are now looking towards both liquid alternatives and hedge fund allocations to answer the well-trodden challenge presented by low bond yields and highly-priced equity markets; by historical standards, anyway.
One of the key takeaways from bfinance’s constant research is that hedge fund portfolio construction has changed significantly from just a few short years ago. It has found that many global and domestic groups are now building hedge fund allocations for the first time, while others are seeking to “refine and improve” portfolios as conditions evolve. This comes after the sector delivered on average double-digit performance for the first time since 2010, according to the authors.
The paper highlights a number of key trends that have grown in recent years, before putting forward an alternative viewpoint when it comes to hedge fund and non-traditional portfolio construction. Fewer mandates are being handed out by asset owners, with the days of employing 50 different managers either directly or indirectly likely long gone. These have been replaced with smaller, more targeted exposures to 10 to 20 different strategies, in the pursuit of less correlated returns.
More tools are being utilised by institutions, who are now looking beyond the traditional global macro and core trend-following options to include the likes of “alternative risk premia” and “multi-asset absolute return” strategies in their allocations. Similarly, there has been a trend towards more managers offering segregated accounts, rather than the pooled accounts that dominated the last few decades, allowing more room for tailored risk management.
Investors are now applying a ’rounder approach’ to portfolio construct with the focus not solely on the investment delivering the best Sharpe ratio, as it has been in the past. Asset owners and investors are increasingly looking for better “tail-risk-adjusted returns,” something that financial advisers, being at the coal face of investor discussions, would know all too well.
The demand for transparency has not slowed, with the Your Future, Your Super changes likely to accelerate this, while the controversy around managed futures and CTA strategies has shown little sign of dissipating. Extended bull markets and an increasingly crowded market have made it difficult for these strategies to deliver on both risk and return objectives at the same time.
“Low statistical correlation is not enough to fulfil the objectives that investors require from an effective ‘liquid alts’ portfolio.” suggests bfinance, with asset owners forced to look beyond the basic correlation benefits towards the impact on both risk and return. While “introducing an uncorrelated strategy…..can improve risk-adjusted returns even if that new strategy itself has an inferior risk-adjusted return,” the premise itself, bfinance suggests, is “flawed.”
The pandemic has forced asset owners and investors to place “less focus on volatility-adjusted returns,” preferring to concentrate more on drawdowns. This, according to the report, requires a more innovative way to look at diversification in the real world.
bfinance suggests alternative strategies be split into four pools that identify their ‘diversification power’:
- Market-independent or ‘low-beta’
- Non-directional
- Convex-directional
- Divergent
Market-independent and non-directional strategies tend to be seeking diversification from long-term and short-term equity market movements respectively, with the latter “structurally” and the former “statistically uncorrelated.” Examples of those defined as market-independent include relative-value-focused systematic macro, relative-value fixed income strategies and long-short credit. Non-directional, on the other hand, is more tilted towards multi-strategy funds along with equity market-neutral and merger arbitrage.
“Convex directional” is for those seeking to hedge the risk of material drawdowns in equity markets like those seen in March 2020. These strategies seek to “generate the bulk of their performance during periods of shock or heightened volatility,” including tail protection along with the traditional CTA and global macro, risk-driven approaches. Finally, divergent strategies seek to profit from “abnormal market regimes” when they are not driven by fundamentals, and tend to be broadly in line with those convex directional options.
“Diversification is very individualistic” and really depends on the individual member and investment profile of each investor, along with the source of fund seeking a hedge. Bfinance currently advocates exposure to both convex directional and market-independent strategies, particularly for those with high exposure to equities.
