The current discussion in Germany about the deregulation of the hedge fund industry highlights an important issue faced by retail and institutional investors: how to find investments that can weather not only difficult market conditions but also offer potential for attractive future returns?
The past three years have shown that traditional portfolio structures are unable to ensure the preservation of capital – let alone to yield the target returns required by insurance companies and pension funds. And there is no indication that this situation might improve going forward. Equity risk premiums for both the short and the long term have been revised downward substantially, which invariably implies low returns on equity investments in the future. In addition, fixed income securities are likely to move in a very tight range and global interest rate levels are expected to remain low for the next couple of months at least.
As investors look to meet their return targets, achieving higher excess returns (commonly referred to as alpha) to compensate for lower market returns has become a necessity. Bygone are the times where investors could afford the luxury of a reliable long-term perspective.
In addition, investors have to face the challenge of a growing correlation between previously largely uncorrelated asset classes.
These developments have resulted in a permanent and markedly lower efficiency curve – see graph. The impact of this is twofold: first, lower expected returns from traditional asset classes have led to a downward movement of the efficiency curve (I). For the investor, this invariably means lower returns for a given level of risk. The second effect has its roots in the higher correlation between traditional asset classes, implying an increase in the overall risk exposure. This has shifted the efficiency curve to the right (II), implying that a higher level of risk has to be accepted to achieve a given return. Investors focussing their portfolio allocations merely on traditional asset classes therefore face a double dilemma: reduced expected returns are accompanied by a higher rate of portfolio volatility.
What are the consequences for investors? Diversification benefits, previously achievable through a mix of asset classes, regions, sectors or market capitalisations, are currently much harder to obtain. Investors who increasingly need to rely upon stable returns (such as insurance companies or pension funds) will therefore be forced to construct portfolios meeting their risk and return targets. Whilst the amendment of Sections 54 and 54a of the German Insurance Supervision Law introduced on 1 January 2002 has brought certain liberalisations, the range of permissible investments, and thus the spectrum of diversification opportunities still remains very limited. As before, insurance companies can only react to market fluctuations in the traditional way – ie, by tactically adapting the allocation to fixed income and equities.

Ways out of the dilemma
The prerequisite for any viable solution must be its ability to push the efficient frontier back up over the long term. Several aspects should be taken into account: Importantly, the level of active risk needs to be increased significantly; this can be achieved by optimising the risk budget of the overall portfolio. At the same time, the risk budget specified by the investor needs to be used in the most efficient way, ie, the available risk budget should be allocated mainly to sophisticated and diligent active management instead of simply taking market risk. As a consequence, the share of active (and ideally, uncorrelated) risks in the portfolio will increase while the risk from market exposure is noticeably reduced. Lastly, adding uncorrelated asset classes to a portfolio leads to a stronger expected long-term return without increasing the portfolio’s volatility and thus its overall risk exposure. Ideally, overall risk will, in fact, be reduced, thus stabilising the portfolio.
Effective strategies with a proven track record of positive contributions to overall portfolio performance include hedge funds, enhanced-index strategies, high-yield investments, as well as currency and overlay strategies. Despite the increasing demand from investors for these alternative investment solutions, the range of strategies on offer is still relatively small. In addition, legal hurdles and tax drawbacks have yet to be overcome. As a consequence, investors continue to allocate funds away from equities into bonds – the drawbacks of such a strategy has been described earlier.
It is therefore not surprising that investors call for a larger range of permissible asset classes including, for example, alternative investments. Studies have shown that excess returns generated from these asset classes have only a small correlation with traditional fixed income or equity investments. Whilst asset classes such as high yield or hedge funds continue to be considered high-risk components of an investor’s portfolio, empirical analysis has shown that in most cases, their inclusion in portfolios can significantly reduce overall risk.
Historical data show that hedge funds produced positive returns comparable to those of global equity investments – with only one third of the risk involved. An allocation to hedge funds can help optimise and diversify an investor’s portfolio, reduce interest rate risks in bond portfolios or volatility of the equity component. Hedge fund managers have the fundamental advantage over traditional managers that they operate in a less regulated environment. As an example, they can hold not only long but also short positions. Thus, they can reduce the impact of positive correlations among securities or take advantage of falling markets. Additionally, hedge funds are not restricted to the investment universe of a benchmark, but are free to pick the most promising investments within the universe of the specific strategy.
Currently, the German investment law (Kapitalanlagegesetz, KAGG) does not allow investing into hedge funds. The reason for this lies in the fact, that hedge funds undertake transactions and use instruments in a way that is not allowed under the KAGG, ie, short selling and leverage. Outside the KAGG context, one could invest in the usual offshore partnership strategy, which in most cases proved to be problematic from a taxation standpoint (Auslandsinvestmentgesetz). Investors, therefore, bought into structures, such as certificates, with the disadvantage of a much higher cost. At the moment, however, regulators are reviewing the KAGG. As a result, hedge funds of funds might become a feasible asset class for separate accounts in the future.
Other low correlation strategies include currency funds or currency overlay strategies. As a number of currency market participants like governments or central banks do not operate on the basis of return maximisation, currencies are generally not correlated to the capital markets. Currency investors therefore stand a good chance of achieving respectable returns by exploiting market imbalances.
Global Tactical Asset Allocation (GTAA) can be another source of uncorrelated excess returns. In the past, some of the results delivered by pure TAA strategies were not satisfactory. Elevating this approach onto a global basis comprises far more investment opportunities than simply the timing of two different asset classes. The concept of GTAA is based upon the attempt to achieve active excess returns by taking up a large number of smaller positions in various countries, currencies as well as asset classes. This strategy is generally structured as an overlay and implemented using derivatives, thereby minimising transaction costs.
In their search for a higher portfolio efficiency, investors can also take a look at the composition of their traditional investments. Most investors follow a strategy which we call the “barbell strategy”, whereby they try to obtain the highest possible excess return by allocating funds between active and passive managers. However, this strategy does not necessarily provide an optimal risk diversification. The “spectrum approach”, whereby enhanced-index strategies are added to the portfolio, thus creating a broad spectrum of investment styles (active, passive and enhanced-index), can noticeably enhance the risk budget as well as the risk/return profile of the overall portfolio.

Outlook
Traditional portfolio management with traditional asset classes and styles is no longer sufficient to ensure the long-term efficiency of portfolios. Uncorrelated asset classes have become a necessity in the quest to raise overall efficiency and achieve steady returns with adequate risks. The search for, and identification of uncorrelated sources of risk (and thus alpha) requires a serious assessment of existing investment restrictions and the establishment of an appropriate risk management process. Investors will look to the regulators for more flexible guidelines on permissible asset classes and maximum allocations as well as for a simplification of current directives and amendments.
James Dilworth, is managing director and head of the investment management division and Claudia Aumann is a member of the investment management division of Goldman Sachs in Germany and Austria

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