By Mark Woolley
With fixed income yields still low and equities looking expensive near all-time highs, some commentators have touted 2014 as the year alternative investments will step into the mainstream.
The returns offered by real estate, private equity and, in particular, hedge funds, relative to the risks that they present, along with the diversification they provide relative to traditional risk assets, make them an attractive investment opportunity for institutional portfolios.
Building a set of hedge fund holdings to address these challenges requires deep insight into overall portfolios as well hedge fund investments, plus the ability to analyse everything in a single framework. Investments spanning multiple asset classes are exposed to a wide range of risks, which can be difficult to measure in aggregate. It is also challenging to relate risk measures to the fundamental drivers of risk, since risk measures are often statistical metrics or backward-looking in nature.
With sufficient data and the right tools, however, it is possible to apply a diagnostic approach to this task. This requires a forensic examination of hedge fund portfolios and performance; mapping against a broad range of risk factors, resulting in a series of comprehensive measures of risk at the portfolio level.
Risk exposures can be categorised in three main types: primary risk factors or market beta’ (for example equity market movements, interest rates and commodity price changes), secondary risk factors (such as equity sector spreads and credit quality spreads) and idiosyncratic risks, or ‘alpha’ (also known as manager skill). Traditional portfolios tend to have the greatest exposure to primary risk and less exposure to secondary risk, with little to no exposure to idiosyncratic risk. Alternative portfolios tend to have the reverse, emphasising idiosyncratic risk.
Hedge funds are measured by their ability to generate alpha. Unlike beta, which is easy to attain, alpha is scarce, difficult to recognise and subject to great variability. BlackRock analysis of the HFRI database of hedge funds in the first eleven months of 2013 shows top quartile managers generated 9.1% of alpha compared to bottom quartiles with -4.1%.
In today’s market, investors should seek to combine risks from both long-only and alternative investments in an intuitive way, evaluating whether a portfolio is overexposed to one or more different types of risk. By reconfiguring hedge fund investments to spread exposure across risk factors, institutional portfolios benefit from better risk-adjusted returns, greater diversification and lower correlation to markets – precisely what hedge funds should bring to a portfolio.
Building a hedge fund investment programme composed of several highly skilled, alpha-generative managers is difficult. It requires experience, a deep network, a comprehensive due diligence and monitoring process, extensive infrastructure, an ability to construct a portfolio to achieve specific objectives and, importantly, the personnel and resources to measure, understand and manage hedge fund risks on an ongoing basis.
But by thinking holistically about risk factors, taking time to identifying genuine alpha-generating investments, and focusing on manager selection, institutional investors use hedge funds as an essential source of returns and diversification to help them meet their liabilities.
Hedge fund investing has reached a new stage of evolution. Once seen as a ‘useful supplement’, allocations to hedge funds have picked up significantly following the 2008 financial crisis. At the end of 2013, HFR data affirmed global hedge fund assets stood at an all-time high of $2.63trn; well above the pre-crisis peak of $1.87trn in 2007. Moreover, a survey by BlackRock in December of 87 large institutional investors, representing over $6trn of assets, found that 28% intended to increase allocations to hedge funds in 2014, compared to just 13% that intended to decrease allocations.
Given our findings on the levels of alpha achievable via hedge fund allocations, this surge in interest is not unexpected and is accompanied by an interesting trend towards ‘bespoke’ hedge fund allocations. Traditionally, investors have had to either invest directly or allocate to commingled fund of hedge fund products.
Recognising the time, resources and ability required to find the hedge fund managers most likely to generate alpha and to avoid those with high beta exposure, institutional investors are re-engaging with experienced partners to help develop highly customised hedge fund portfolios, or ‘solutions’. When done correctly, this results in overall portfolios which are fine-tuned to pursue specific objectives relating to risk-adjusted returns, correlations, volatility, diversification and downside protection.
Mark Woolley is head of hedge fund research EMEA, BlackRock Alternative Advisors
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