Concerns over performance and value for money have put some institutional investors off hedge funds, but is this justified? Cardano’s Dev Jadeja discusses how trustees can evaluate whether the strategy is right for their scheme.
Action points
Build a diversified portfolio asset mix based on robust and clear risk-return objectives
Take the economic cycle into account when evaluating potential investments
Ignore strategy labels and evaluate the value proposition with a key focus on diversification
Value for money and disappointing performance versus passive market indices are often given as primary reasons by many investors.
Do not focus solely on historical performance
In a challenging performance environment, many investors have, logically, questioned the value of allocating to active strategies over cheaper passive options.
Whatever the label on a strategy, it makes little sense to overpay and increase complexity for something that is indistinguishable from a cheaper, simpler alternative
After a long bull market (currently in its ninth year) it is only natural some of these diversifying strategies have come under increased scrutiny; historical performance can often be the key consideration in asset allocation decisions, in many cases prioritised over consideration of the risk taken to achieve it.
The decision to cut diversifying strategies following the recent history of strong market performance is a dangerous one. Calm markets often build a false sense of security but, in the long term, diversification should always be at the heart of any robust portfolio.
Firstly, investors thinking about hedge fund allocations should avoid too much focus on the label ‘hedge fund’. The term is broad and covers a wide variety of strategies, albeit underpinned by a flexible and active approach adopted by the manager. Some multi-asset diversified growth funds have similar traits and could also be included in the same bracket.
Think holistically about return objectives
Given how broad the strategy label is, a more appropriate question could be: “What is the purpose of these strategies in my portfolio?” Costs are important, but the assessment must extend beyond this one factor alone.
Will the strategy enhance your portfolio return after fees, diversify your risk or preferably do both? A pension fund should think holistically about their return objectives and the risks they can tolerate to achieve them.
Return expectations for traditional assets should vary with the economic cycle. If you have a cautious outlook on these, what are the other options out there to achieve your return objectives and how do hedge funds fit in?
Just like any investment, a pension fund must consider how the environment could affect prospective returns from a hedge fund or DGF in the context of their existing portfolio. If a portfolio already has significant traditional asset exposure and the strategy under review also tends to have high market exposure, it clearly offers limited differentiation.
Whatever the label on a strategy, it makes little sense to overpay and increase complexity for something that is indistinguishable from a cheaper, simpler alternative.
The same applies when it comes to other ‘hedge fund’ strategies, which can sit at the higher end of the cost spectrum. Value for money is a crucial part of the evaluation process.
Careful selection is crucial
But, when it comes to any flexible active strategy, the first and most important question is: do you believe you have the capability to identify skilled managers who are able to produce active outperformance over and above the fees they pay? The recent Competition and Markets Authority review challenges the notion that many investment consultants are capable of producing these results.
If your consultant or fiduciary manager has manager selection capability, the next question is whether the manager incentivisation is aligned with your portfolio objectives?
In some situations, there can be creative ways for investors to improve the alignment/value proposition. Take the example of a stock-picking hedge fund that seems to offer some diversification (which is valuable) but looks expensive, especially as it tends to have some structural long equity market exposure (which is not valuable). If fees were adjusted to be contingent on outperforming an equity market hurdle, the value proposition could look more interesting.
Measuring value added for active strategies (including hedge funds) relies on a clear framework that includes the diversification potential. We believe a careful selection of such strategies can be a useful tool, among many, to build well-diversified portfolios.
Dev Jadeja is a trading strategies investment analyst at Cardano
