Hedge Funds

These are private investment funds investing primarily in the global equity and fixed income markets. We also loosely include alternative mutual funds and actively managed structures in this category. They typically employ sophisticated trading strategies and are leveraged. Hedge funds come in different flavors regarding their mix of beta and alpha return components. While many claim to be “absolute return” providers, meaning that they would provide positive returns regardless of the broad market ups and downs, few genuinely are. While their hedging activities generally tend to reduce hedge fund’s correlation with long-only investments, thereby providing portfolio diversification, that is not always the case. They do retain some “net long” exposure and may have some elements of leverage too. In addition, they are not immune to the illiquidity risk of the broader market.

  • Hedge fund managers have the flexibility to invest opportunistically in strategies where they see value. By contrast traditional money managers are often constrained by rigid mandates to invest in pre-defined markets.

  • They tend to use leverage to increase returns. Much is made of this, but the reality is that, on average, leverage is usually not too high - usually 2 to 3 times.

  • Their performance is dependent on investing skill, rather than just market exposure.

  • They have historically exhibited moderate correlation with traditional financial market indices - though this is probably truer over long periods of time. In the short-term correlations, can, and often do, rise.

  • They typically also have reduced liquidity with monthly to multi-year lock-ups.

  • Their managers typically charge higher fees, which may include performance fees.

There are four major hedge fund strategy groups with over 20 sub-types. This makes asset allocation and portfolio construction very complicated. Allocating is especially difficult for it involves comparing fund manager returns to asset class returns. Appropriately defining and measuring alpha (skills derived returns) is hard. Dealing with varying degrees of downside risk brings its own challenges. And then there is the problem of accounting for short track records and the chance that forecasts are wrong.

Hedge fund strategies have exhibited considerable instability … implying classification errors which will hinder traditional portfolio allocation. Its implications are traditional categories not reflective of underlying strategies over time. There is considerable “Strategy drift” which reduces benefits of diversification. It also violates the asset allocation principle: forecast only when there is stability.

We remove biases in reported returns, account for factor driven market exposures and separates systematic exposures from tactical bets. By integrating multiple information sources, we explicitly forecast alpha, instead of total return. We blend historical data with other information to build more accurate forecasts. We penalize for downside risk so that you can integrate forecast risk into portfolio construction. Our approach also allows us to explain more systematically how much return each hedge fund strategy creates returns through systematic factors and how much is generated by factors unique to a specific strategy.

Our research driven approach highlights many important implications for investors and their advisors:

  • All hedge fund strategies are not alike. Our research shows that while some strategies might have very little exposure to systematic factors (such as equity market neutral, fixed income arbitrage and merger arbitrage), others have much greater exposure to systematic risks (such as equity long/short and distressed).

  • A significant portion of many hedge fund strategies is based on the skill of the managers. Concomitant to the exposure to systematic factors, a portion of returns in every strategy is unrelated to systematic exposures. We attribute this “alpha” to the skill managers have in identifying and executing trading opportunities, selecting securities, and timing various markets.

  • The broad range of exposures means that hedge funds can act as effective diversifiers in a portfolio. While the systematic exposures hedge fund managers have in some cases explained a significant portion of their returns, two important points stand out for investors. Every hedge fund strategy has simultaneous exposures to many of these factors. In other words, unlike many long-only managers, whose returns can generally be explained in large degree by movements in a single market, hedge fund strategies are not exposed to any single systematic factor. Thus, at the strategy level, hedge fund managers diversify these exposures against each other. This means that any specific “bet” reduces the correlation among the strategies. In addition, because many of the factors to which hedge funds are not exposed do not form elements of most investors’ portfolios, hedge funds of almost any type can indeed act as an important diversifier in a portfolio of many asset classes. As market events are reflected differently in each strategy and in each fund combining a portfolio of funds with different but complementary investment styles and risk/ return attributes is desirable. However, a naive diversification across many funds and strategies may be suboptimal in that it may not be fully effective in reducing market and credit risk, or specific risk of a fund.

  • By arbitraging a combination of market, credit and liquidity risks, hedge funds can implement a variety of directional and non-directional strategies. We help you combine different hedge fund strategies to create exactly the type of directional, semi-directional, or non-directional exposure your clients need. In our framework, we are not prescriptive. You arrive at your own views on markets. The degree of directional exposure you may want to take or not take. What we do offer, are ways to allocate to take on that exposure.

  • Estimating projected alpha and alpha volatility for each strategy/HF.

  • Estimating historical beta exposures for each strategy/HF.

  • Incorporating uncertainty in alpha forecasts, alpha volatility estimates and beta estimates through confidence interval measures.

  • Keeping in mind downside risk characteristics of each strategy’s/HF’s alpha.

  • Correlations across different strategies’/HFs’ alphas and betas.