Hedge funds still present a number of difficult analytical problems for those who wish to integrate them into a traditional approach. To achieve success, it is important to ensure that the objective of the hedge fund allocation is clearly defined at the outset and that expectations regarding return potential and risk characteristics are understood.

Assessment of the portfolio objectives
The first and most important step in customising a customer’s hedge fund portfolio is to establish its objectives. The investment horizon, risk ‘appetite’ and awareness, as well as legal, fiscal and other often unique investment needs have to be taken into account. Based on those issues, and taking the potential needs for liquidity into account, an asset allocation strategy is established. Efficient frontier modelling, based on the average expected return as well as standard deviation covariance calculation between the return series, is used to evaluate various asset allocation possibilities in order for the optimal portfolio allocation to be established.

Portfolio construction
The architecture of the proposed portfolio is based on an intense analysis of the current market dynamics to determine a strategy allocation (top-down). Individual managers are then scrutinised within each strategy to construct a portfolio structured to optimise capital preservation (bottom-up). It is essential to note that this analysis is both quantitative and qualitative in nature and is not undertaken in an attempt to ‘time the market’ or predict market direction. Additionally, the portfolio proposal should exhibit the following characteristics:
q low volatility;
q low downside correlation to major market indices;
q adequate liquidity;
q low leverage.
Rigorous testing of a portfolio proposal is performed using historical data, with particular attention paid to the previously mentioned characteristics. Managers will be eliminated from consideration if:
q in the hedged equity area the manager: employs high gross leverage; does not consider beta mismatches in the portfolio; fails to adjust to volatility swings, and generally lacks portfolio sophistication or adequate risk control measures.
q in the relative value/arbitrage category the manager: employs excessive leverage; lacks portfolio diversification/ runs a highly concentrated book, and maintains large volatility exposure.
The cornerstone of a portfolio proposal, and all thoughtfully constructed investment strategies, is an acute attention to the risk/return parameters deemed appropriate within the current macro-economic climate.
Strategy analysis
Given pre-defined parameters as outlined before, the broad strategy allocation is established and a sample of this is shown in the chart. The allocation should protect against downside risk to provide a more consistent and less volatile return.

q Hedged equity
A hedged equity manager can theoretically use a variety of different investment styles and very few confine themselves to a narrow and well-defined area. Examples of investment styles include:
l focus on different market caps, sectors and regions;
l growth stocks versus value stocks;
l longer-term investments versus shorter-term trading;
l diversification (number of stocks in the portfolio and sizing of positions);
l exposure levels.
Theoretically, the hedged equity universe, with over 2,000 different funds worldwide, should be large enough to be classified into different sub-strategies. Unfortunately, the vast majority of managers do not confine themselves to initiating positions in a pre-defined universe, such as growth or value, nor within a specific market capitalisation band. Most managers are very opportunistic in order to take advantage of sector moves and/or themes prevailing in the market. Further, some managers manage the short book differently from the long book (eg, short deteriorating growth companies and long small cap value companies). In such a case, the long and short book must be viewed as two different portfolios.
Long and short positions will vary in terms of growth versus value, across the market capitalisation spectrum and through sector concentration on either side of the portfolio, resulting in beta mismatches. Most hedged equity managers are aware of such mismatches but only a few manage them actively. Therefore, it is not surprising that the risk/return profile and the performance pattern of different funds is widely spread across the hedged equity universe. Some managers in this area even have negative correlation to each other.
Additionally, it is important to note that hedged equity managers are highly sensitive to capacity, because they face consistently increasing difficulty in executing trades as the fund grows in size. As a consequence, a style shift can often be observed as a manager uses a longer-term horizon for its investments in concert with a shift to larger capitalisation stocks as the managed asset pool increases.
Given the opportunistic investment style, combined with the lack of a significant number of data-points, it is very difficult to draw conclusions from a manager’s track record alone. As a consequence, the qualitative assessment of a manager, of his trading style and especially of his risk management techniques is crucial.
When evaluating risk, it is critical to determine the risk of a fund both ex post and ex ante (especially for funds with shorter track records):
l ex post: based on historical performance figures such as maximum drawdown, volatility and downside deviation. How did the fund perform during difficult periods for the market/industry?
l ex ante: focus on risk management, such as stop-losses on a stock and a portfolio level. Review leverage used, diversification, beta mismatches and liquidity, especially on the short side.
To mitigate the volatility of a hedged equity portfolio allocation, it should be constructed in such a way that potential drawdowns at the fund level do not occur during the same period of time. To achieve this goal, such a portfolio has to be well diversified in terms of regions, sector exposures, market capitalisation and value versus growth stocks.
This can be achieved in four ways:
l through the selection of funds to maintain a balanced portfolio and concurrently avoid significant exposures to any of the aforementioned areas;
l through the combining of funds that have offsetting characteristics;
l by selecting funds that have a low and limited correlation to each other and to major indices;
lthrough regional diversification.

Conclusion Since most hedged equity managers actually do have mismatches in the portfolio, the vast majority of funds would have to be excluded if we sought investments in funds with a balanced portfolio only. In conclusion, a diversified hedged equity portfolio portion should be constructed to limit exposure to, and concentration in, specific markets and sectors, any particular market capitalisation and value or growth stocks exclusively.

q Global Macro/CTA
The current world economy has taken on a generally bleak picture. In the US, weak economic data, massive corporate layoffs and lower corporate earnings have not cut into consumer spending. With low inflation and weak commodity prices, the Federal Reserve has been aggressive in lowering short-term interest rates. Europe has weakened, but their policy makers have not been as aggressive as their US counterparts in lowering short-term interest rates. Japanese equities have hit multi-year lows recently and all attempts to prop up the economy have failed. With all this turmoil, trends in global fixed income markets, global stock indices and world commodity prices have been evident. Many global macro managers and CTAs have taken advantage of the current situation in recent times. Thus, we deem it important to include these managers in our allocation approach.

Description There are six different types of managers in this space. We have hence built peer group composites to characterise each different type (see table 1). In addition, the correlation between the different types of managers has been calculated (see table 2).

Conclusion The use of other strategies within the Global Macro/CTA space has allowed us to achieve our goal of superior risk-adjusted returns. Therefore, our premise of adding uncorrelated returns to our portfolio has been supported.

q Relative value/event-driven
These strategies seek to benefit from trading anomalies created between related securities in the equity, fixed income and derivatives market and include a vast number of ‘sub strategies’ (such as fixed income arbitrage, convertible arbitrage, statistical arbitrage, merger arbitrage and many others). With a focus on taking advantage of trading opportunities created within the market, not market direction, these strategies historically tend to have very little correlation to the global equity and fixed income markets: 0.35 versus the NASDAQ over the last 10 years. Although over the last three years, since a large majority of the transactions in the merger and convertible arbitrage trades was mainly technology orientated, the correlation versus the NASDAQ has been 0.50. Return profiles and leverage differ substantially between managers and styles.
The difficulties experienced in equity markets and the uncertainties in current market conditions have led to a large inflow of money into relative value strategies since the returns are considered to be more bond-like in nature (typically more consistent and steady).
In volatile market conditions these types of return are very attractive and have led to large inflows. These large inflows and lack of attractive opportunities in these markets recently have created limited opportunities with tight spreads in the case of merger arbitrage and unfavourable pricing in terms of convertible arbitrage.

Conclusion The overall objective of the relative value event-driven portion of the portfolio is to diversify exposure into low leverage and low volatility managers outside the typical arbitrage strategies, ie, merger and convertible arbitrage.

Summary
The primary objective of our hedge fund portfolio proposal is capital preservation. In this regard, the strategy, style and ultimately manager selection process of the Julius Baer Non Traditional Fund team concentrates on low volatility, reasonable leverage and acceptable liquidity of investments. This methodology reflects our defensive capital preservation approach.
Barbara Rupf is head of the Non Traditional Funds team at Julius Baer. She joined Julius Baer in 1993 to build up and head the fixed income brokerage section. In 1999, she was appointed CEO of creInvest AG, a fund of hedge funds initiated by Julius Baer and listed on the Swiss Exchange. She went on to head the Julius Baer Non Traditional Funds team in spring 2001. Mrs Rupf started working in the banking industry in 1985, joining JP Morgan in its International Private Banking division. Prior to 1993, she worked for four years in sales and restructuring (asset swaps) of Asian debt at Nomura Securities and Mitsubishi Bank in Zurich, London and Tokyo. Mrs Rupf holds a BA degree in Economics from San Jose State University, California and graduated from the Swiss Banking School in 1998.

The investments discussed in this article may be unsuitable for certain investors depending on their specific investment objectives and financial position. Julius Baer Institutional Asset Management is the institutional fund management business line of the Julius Baer Group. This document is issued by Julius Baer Investments Limited (“JBIL”), which is regulated by the Investment Management Regulatory Organisation Limited. With the exception of Julius Baer Investment Management Inc. London, none of the other companies within Julius Baer Institutional Asset Management is regulated in the United Kingdom for the conduct of investment business

Topics