Building portfolio resilience: Should schemes consider hedge funds?

With concerns about inflation spiralling out of control, looming central bank action, and the unfolding Ukraine crisis, investors have been reminded of the need to build resilience in their portfolios. 

Could 2022 be the year that pension schemes consider a hedge fund allocation to mitigate volatility and build in portfolio resilience?

Given the market’s decade-long bull run, investors could be forgiven for not having considered some of the typical diversifying assets, including hedge funds.

The biggest benefit of a hedge fund allocation is its ability to mitigate market risk through diversification

Indeed, many hedge funds have underperformed their objectives, especially during challenging markets when they were supposed to act as a diversifier.

They are more complex to implement, fees are often much higher compared with traditional asset classes, and environmental, social and governance integration is not always available.

Hedge fund strategies are also often perceived as controversial, so it becomes clear that a decision to invest in these strategies must be taken carefully.

The objectives will determine the approach

Schemes must be clear on their objectives when deciding whether to allocate capital to hedge funds.

Some investors can stomach volatility and extensive drawdowns, but for those with a less positive market outlook and who value a steadier return profile, investing in hedge funds can play a vital part in maintaining a diversified and more resilient portfolio.

The biggest benefit of a hedge fund allocation is its ability to mitigate market risk through diversification.

Given today’s unsettled markets, pension funds can target cash plus 3-4 per cent return through a hedge fund allocation.

Though it is a more conservative target compared with long term expectations for equities or illiquid alternatives, under the current market conditions it looks relatively attractive.

While investors could aim to target higher returns with their hedge fund allocation, they should be aware that the more you stretch your return target, the more likely you will have to accept either greater sensitivity in down markets or lower predictability of outcomes — in other words, higher volatility.

A well-managed portfolio with more prudent targets is likely to hold up better in a market sell-off, boosting a scheme’s resilience.

Implementation is key

Implementation of a hedge fund allocation is often a challenge for many schemes, as it requires significant expertise and resources.

To build portfolio resilience, schemes must identify skilled managers who can generate returns without introducing market sensitivity at the times when diversification is most needed.

It is also well known that hedge funds are not cheap. Therefore, it is important to analyse the potential value added and to pay the right price for it. Even then, smaller schemes will struggle to negotiate favourable terms with the right managers.

One option is to implement a hedge fund allocation through a third party. These can manage the process and help provide access to highly skilled managers and negotiate fee discounts leveraging their size and an agile governance model.

While the impact of a potential extra layer of fees that comes with outsourcing should be carefully considered, the investment merits of a well-managed portfolio should outweigh the extra costs (costs that may be offset by negotiated fee savings).

Integrating ESG

ESG integration is increasing rapidly and ESG investing is soon expected to become the norm. Hedge funds are starting to realise that too.

While investors have to be extra careful that they do not fall for any form of ‘greenwashing’ when allocating capital, there are many valid reasons why schemes would want to integrate ESG into their portfolios — not least because it is an important reputational and investment risk factor.

There are also clear diversification benefits for schemes adding managers with an ESG lens to their portfolios. By looking for further opportunities to tap into differentiated sources of returns, ESG integration may help schemes achieve the ultimate objective of a steady, uncorrelated return.

All things considered, and when implemented correctly, hedge fund allocations can be a vital asset to pension schemes targeting steady returns.

If the start to 2022 has signalled one thing, it is that heightened uncertainty is likely to persist. Now may be the right time for schemes to take a serious look at hedge funds as part of a diversified, resilient portfolio.

Guy Saintfiet is a senior portfolio manager at Aon