Barriers to entry such as poor information, high minimum investments and low levels of liquidity have long prevented the majority of investors from taking advantage of the benefits of alternative investment strategies in terms of risk reduction and return enhancement.
Recently, however, the development of funds of hedge funds (FoHF), fostered by an attractive value proposition (asset allocation, risk management, due diligence, fund selection), and lower entry tickets, has considerably widened the range of potential investors. According to data collected from the AAC database, the flip side of this commercial success is a significant decline in the performance of FoHFs (to account for any survivorship bias both operating and defunct funds were included in this analysis). For example, the mean annual return fell from 17.34 per cent to 5.85 per cent while the worst annual return decreased from -15.65 per cent to -19.32 per cent.
In the meantime, a series of investable hedge fund indices (henceforth investable indices) were launched, providing investors with a lower-cost solution to gaining exposure to hedge fund strategies. However, are lower costs necessarily synonymous with better investment opportunities? To answer this question we will try to understand whether FoHFs and investable indices respond equally to the needs of: an aggressive investor looking for absolute returns (alpha logic); and a defensive investor looking for diversification opportunities (beta logic).
While hedge funds have long been considered to be black boxes that aim to generate alpha, most studies carried have concluded that: one, they do not systematically obtain positive risk-adjusted returns; and two, there is only weak evidence of persistence in their performance. Taking advantage of hedge fund alpha is thus a challenging task.
If it is at all possible to capture the abnormal returns of hedge funds, this is done better by FoHFs than investable indices, since the former may add value through the allocation and fund selection processes, while the latter are passively managed FoHFs that externalise the selection process.
Product selection
However, selecting FoHFs turns out to be as challenging a task as selecting hedge funds - assessing the fund allocation and selection processes requires good knowledge of the specific characteristics of hedge fund strategies.
Using hedge fund strategies as return enhancers thus turns out to be reserved for experienced investors with good FoHF or even hedge fund picking ability.
Unfortunately, it therefore appears that neither FoHFs nor investable indices are really suited to providing investors with secure access to hedge fund alphas. On the one hand, there is extensive evidence showing that good fund picking ability is rare, and cannot always make up for the double fee structure of FoHF.
On the other hand, funds entering into the composition of investable indices are generally selected by the managed account platform teams with respect to issues related to additional capacity, redemption frequency, infrastructure, transparency or length of track record, and not risk-adjusted performance.
Identifying and capturing hedge fund alpha is extremely difficult. Fortunately, exploiting their betas (exposure to risk factors) turns out to be much more feasible. It is thus often suggested, for diversification purposes, to introduce hedge fund strategies into institutional investor portfolios. There is, however, a naive and a more meaningful way to do so.
The naive approach consists of adding a low-volatility FoHF to a traditional portfolio. Provided that the FoHF’s level of volatility is lower than that of the initial portfolio, this naive approach leads to a proportional decrease in the global portfolio volatility. In this case, diversified FoHFs appear to be better armed than composite investable indices since the former can follow active strategies that aim to provide better risk control. Consequently, they lead to potentially lower levels of volatility.
A more mature approach consists of integrating hedge fund strategies into the portfolio’s global asset allocation process. This approach is more demanding since it requires in-depth knowledge of the specific risks of hedge funds (extreme risks, dynamic and non-linear exposures to multiple sources of risk, etc.) to reach an optimal solution, but we have found that it may yield spectacular results in terms of normal and extreme risk reduction. Since diversified FoHFs and composite indices are off-the-shelf products, they present limited interest in this case. Specialised FoHFs and single strategy indices, on the other hand, may be used to design optimal portfolio diversifiers.
Maximum diversification
In this respect, since investable hedge fund indices offer better transparency and increased liquidity, they allow for better control of risk through dynamic strategies. Customised portfolios of investable hedge fund indices should therefore produce enhanced diversification effects relative to FoHF, notwithstanding the fact that they offer a lower cost solution relative to specialised FoHF.
Common sense suggests assessing the interest of an investment vehicle in the light of its application. Edhec therefore investigated whether FoHFs or investable indices are better suited for investors following either alpha or beta logic. It seems that for investors looking for alpha, the “lesser of two evils” is the FoHF solution.
Nevertheless, non-expert investors are recommended to think twice before pursuing alpha logic, and it is suggested they opt for the beta logic. To this end, using optimally designed portfolios of investable indices seems the best option.
Mathieu Vaissié is research engineer at the Edhec Risk and Asset Management Research Centre
