Devoted followers of modern portfolio theory have had a difficult time over the last 15 years. Investors hoping to diversify their portfolios by mixing asset classes have faced the October 1987 equity market crash; the Gulf war in 1990; the crash of the global bond market in 1994 and the crash of the spread market in 1998.
History has shown that the only thing that increases in bear markets is correlation and here, hedge funds may provide a solution to achieving exposure to asset classes that don’t correlate in down markets and do offer diversification.
The hedge fund world is large and growing with an estimated 5,000 funds offering investment in a wide range of styles such as global macro, long short equity, arbitrage, event driven, CTA. There is also a wide range of manager styles and picking and allocating money to only one hedge fund in this jungle would be a challenge for any institution.
The importance of diversification in the traditional investment arena is well recognized, but in the hedge fund sector, where the main risk is an operational one, it is even more important. Investing money in only one hedge fund is closer to taking a bet in a casino than a rational investment process, particularly if the only hedge fund investment in 1998 had been LTCM. Clearly, the investment manager needs to diversify his portfolio across both manager and strategy risk.
The true beauty of the different hedge fund styles is that they can offer structurally decorrelated performance. The lack of correlation is due to the lack of common investment approaches in each style. So, in order to achieve diversification, the investor needs to search out fund styles with low correlations and reduce the volatility of his or her portfolio by creating a multi-hedge fund portfolio.
Creating a multi-adviser fund is not a simple business. Picking and monitoring hedge fund strategies requires a highly qualified and experienced research team. Hedge funds need to be analysed both quantitatively and qualitatively. Their managers’ investment strategies are generally complex, but it is also a people business. Few pension funds would find it economically viable to set up internally and maintain a team that could undertake this level of monitoring and analysis.
One route open to the investor is to use a fund of funds. While, by definition, a fund of funds is just a basket of different fund names, this is clearly not enough. In reality a true fund of funds should be a ‘diversified pool of strategies or styles’. By diversified, we mean strategies that are structurally non-correlated. For example, long/short equity strategies are unlikely to correlate on the downside with convertible bond arbitrage strategies which would mean that their combination would bring diversification to a portfolio. An example of a mix which wouldn’t work is in the case of a fund of funds that invested only in long/short equity managers, all of whom were long of technology stocks at the end of the last quarter. (Any resemblance to current events is obviously coincidental….) This type of portfolio is not going to happen if the fund of funds is managed by people applying a proper stylistic diversification process.
What differentiates a fund of funds from a multi-style hedge fund portfolio is the rigour of the investment process followed by the company responsible for the asset allocation. Ideally, this process should be separated into three distinct steps and be totally transparent:
o Firstly, the adviser needs to understand the clients’ objectives. There is no one pre-packaged multi-style portfolio suitable for every pension fund. These portfolios should be customized depending on each client’s asset allocation needs.
o Secondly, there should be a rigorous selection of hedge fund managers based on qualitative criteria, confirmed by statistical analysis. Emphasizing the qualitative approach is crucial as experience shows that past performance is no guarantee of future results. What gives a reasonable indication that the past can be repeated, is a clear understanding of the manager’s investment process, risk control and how the hedge fund manager adapts to new market environments.
o Thirdly, there must be proper diversification following a rigorous portfolio approach through a mix of strategies suited to reduce overall portfolio risk.
As a natural consequence of the rigorous selection process, a multi-style hedge fund portfolio will generate less spectacular performance than a typical fund of funds with concentrated (consciously or not) style allocations, but it will equally generate less volatility. This process is likely to meet institutional objectives, searching as it does for good risk/return characteristics rather than simple returns.
The typical fund of funds allows investors to obtain exposure to a basket of funds with a low minimum investment, typically $100,000. We estimate that in order to achieve true diversification, the minimum portfolio size needs to be about $25m as each underlying hedge fund has its own minimum investment requirement, typically $1m.
Pre-packaged funds of funds can be useful for small to medium sized pension funds, who do not wish to commit too much capital for a strategy which is new to them. But, over time, as exposure and knowledge increases, pension funds should ask for a separate managed account to mitigate the risk of having other shareholders in the fund of funds with different liquidity needs or constraints. During market crises, such as the 1998 drawdown, some funds of funds were badly hurt by a wave of panic redemptions from highly leveraged private investors.
Pre-packaged, simple funds of funds offer pension funds an initial exposure to the hedge fund arena, as long as the investment process driving the asset allocation follows rigorous stylistic diversification. If this is done, then the pre-packaged fund of funds portfolio will have good risk/return characteristics which will also allow a pension fund to achieve appropriate diversification from its traditional exposure to directional market risks, without having to hire a team of specialists. Beyond that, if the size of their allocation permits, pension funds should go one step further and request a separate ‘customised’ portfolio of multi-style hedge funds.
Michel Donegani is head of asset allocation and manager selection at EIM, in Nyon, Switzerland

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