A Hedge Fund Investment Philosophy
In this follow-up to my Active vs Passive Management investment philosophy piece, and as I have developed a Fund of Hedge Fund product, I want to go into some more detail on my hedge fund specific investment philosophy. As noted in my previous article, I believe active management should only be used in three situations:
- for market risk-neutral ‘new’, or not-well-known, factor risk capture not available via passive investment vehicles,
- for market risk-neutral idiosyncratic risk capture that has a defined edge, and
- alpha return capture. Hedge funds are of course an active investment and therefore I hold them to my above return driver criteria.
Hedge Fund Trends
Firstly, I believe that the hedge fund market is oversaturated. In my opinion, there are too many hedge funds running the same type of strategy. I am on a number of Cap Intro lists and, on average, I would say about 75% of the hedge funds being promoted are some form of directional equity L/S. This is one of the many areas where I believe the number of hedge funds will significantly decrease in the next 5-10 years; the main reason for this refers back to my piece on the current macroeconomic climate, where I speak to an increase in cross asset-class correlation. An example here is just last year when the S&P 500 increased around 29% while passive long-only US Municipal Bond indices increased about 8%. Traditionally these two indices had a high negative correlation, but we are currently seeing a broad-based beta rally. This has made it very difficult for hedge funds to beat their passive beta benchmarks and will cause a large number of hedge funds to close as investors redeem due to a lack of outperformance.
Secondly, the broad-based beta gain has also had another effect within the hedge fund world which I believe will continue - a lowering of manager fees. The traditional 2&20 has become closer to an average of 1.5&15 – there are of course some funds out there charging the traditional 2&20 but, generally, we are seeing a lowering of fees. Referring back to my previous Active vs Passive Management piece, where I speak about the parity return required by hedge funds to just match the returns of passive investment products, and given the broad-based beta drive over the past decade as described in the S&P and Municipal Bond example above, hedge funds need to lower their fees in order to lower the parity return to give them a better chance of outperforming their beta-driven benchmark. Another reason for the fee drop is due to the large number of hedge funds all fighting for a decreased overall pool on investment within the hedge fund market given the difficulty of outperformance over the last decade. To borrow a term from real estate, the hedge fund market is currently an ‘investors market’.
What is a Hedge Fund and are Hedge Funds their own asset class?
Before getting into my hedge fund investment philosophy, I must first answer the question ‘what is a hedge fund?’ [You’d be surprised how many people can’t give a definition for it]. Hedge funds are quite simply an investment vehicle with pre-agreed terms and conditions between the manager and the investor(s). These pre-agreed terms and conditions, in a non-exhaustive list, cover fees to be paid by the investor(s), liquidity terms or ‘lock-up and redemption period’, what market(s) the manager can trade within, the product(s) the manager can trade/use as well as the fund’s strategy.
The follow-up question is ‘are hedge funds their own asset class?’ There is not one ‘correct’ answer. Each investment professional will have their own opinion. Personally, I do not believe hedge funds are their own asset class because they do not necessarily have their own unique market exposure and return behavior. Let’s use 2 different examples to explain my belief on why hedge funds are not their own asset class. Assume a Qualified Investor was recommended an asset class investment breakdown as the following - 30% in equities, 20% in bonds, 10% in FX, 15% in commodities, 15% in real estate and 10% in hedge funds.:
- Let’s take our 10% hedge fund allocation and invest it in the most common strategy - equity long/short. Let’s also assume that the average beta coefficient of US equity L/S is 0.75 to their major Index – the S&P 500. If we invest our hedge fund allocation all in the equity L/S hedge funds, we are essentially just adding 7.5% of our exposure to the 30% exposure in the equity asset class and adding 2.5% exposure to something else; to know what the 2.5% is tied to, we would need to run further analysis. One could argue only 25% of the investment in the hedge fund asset class is actually derived from an alternative asset class and 75% of our hedge fund asset class is essentially just the S&P 500.
- Take 5 different Hedge Funds (HFa through HFe); HFa trades within equity markets, HFb within bond markets, HFc within FX markets, HFd within commodity markets, and HFe within the real estate market. By investing in any one of the above hedge funds, or all of them together, we are not investing in a unique market exposure relative to the rest of our portfolio [90% of our investment portfolio] – we are just adding the representative amount in to the asset classes/markets we are already invested in. Does investment in any of the above 5 hedge funds truly bring in a differentiated market exposure to the 10% of our overall portfolio invested in hedge funds that we are not already getting exposure to by the other 90% of our investment portfolio?
Despite my above believe that hedge funds are not their own asset class, I do believe that a synthetic hedge fund asset class can be created by utilizing the liquidity and tradable markets characteristics, which are unique to the hedge fund investment vehicle relative to their cheaper investment vehicles, in order to gain exposure to strategies and non-traditional markets that have different fundamental drivers than the other asset classes. I refer to these, relatively few, hedge funds that provide the aforementioned return behavior/different fundamental drivers as their own ‘alternatives asset class’.
‘Alternative Asset Class’ Traits
In order to find a hedge fund within my ‘alternative asset class’, the hedge fund needs to exhibit three primary traits: low beta, high alpha and diversification of an investor’s portfolio from an overall portfolio perspective. Let’s dig into these three traits in a little more detail.
I will get into beta in more detail in a future post. From a high level, however, depending on your market theory, beta is either just one factor (general market exposure - CAPM) or multiple factors that are economically driven. That means that if the hedge fund’s strategy is significantly open to price movements based on these factors, they will naturally have a medium to high beta coefficient. With this in mind, what strategies do I disregard in order to screen out medium to high beta exposure?
The majority of the strategies I rule out due to too high of a beta coefficient are the major hedge fund strategies. Generally, I rule out directional equity L/S, macro global, trend-following and CTAs. The primary reason why I rule these strategies out and why they have medium to high beta coefficients is due to the directionality of their trades. For this reason, I try to avoid directional trading and concentrate on hedge funds that take advantage of market structural inefficiencies to try to target low beta funds.
I will also get into alpha in more detail in a future post. From a high level, however, the Efficient Market Hypothesis says that consistent alpha is impossible; CAPM defines alpha as an excess above the market return and APT defines alpha as the excess above the multiple economically derived factors that move asset prices. I look to hedge funds to bring in risk-adjusted alpha that is derived from non-traditional market exposures that cannot be obtained via cheaper investment vehicles and via strategies that are taking advantage of structural inefficiencies within a market or strategies that can only be traded through the ability to having a longer liquidity lockup.
My hedge fund investment philosophy provides two layers of diversification. The first layer is a natural byproduct of the low beta to traditional asset class component as the fund’s return is driven by different factors than what drive the other asset classes. This will naturally provide a portfolio diversification benefit - just like combining a commodity portfolio with an equity portfolio. The second layer comes via setting a screen where the hedge fund’s return must not only be uncorrelated from the market’s systematic risk, but they must also be uncorrelated to cheaper investment vehicles within the traded market - the most traded market ETF(s). This means that even if you have exposure to a market that an underlying hedge fund is trading within, the hedge fund is still bringing in differentiated returns than the passive investment which helps further diversify the investor’s overall portfolio.
Bonus Trait – Specialization
I look for single market experts, each of which are within my ‘alternative asset class’, versus multi-strategy hedge funds. I, generally, do not consider allocating to multi-strategy hedge funds as the rest of an investor’s portfolio (outside of their alternative asset class) is essentially a multi-strategy portfolio providing the natural diversification that a multi-strategy hedge fund within the traditional asset classes brings in.
There you have it – my hedge fund investment philosophy which, I believe, is quite differentiated. I also believe that the types of hedge funds within my investment universe are very different than the hedge fund investment universe of others.
Karl Rogers is Founder of ACE Capital Investments, an Irish-based Investment Consultant
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