In the first article in this series, we looked at how the new HFR indices are game-changing for hedge-fund allocations because they provide genuinely investable hedge-fund benchmarks. In the second, we looked at how the various HFR indices and sub-indices offer an efficient tool for portfolio construction, risk budgeting and asset-allocation purposes. In this article, we want to explore the implementation options the investable indices offer. We also aim to examine the benefits the indices may provide for investors once a decision to allocate to hedge funds has been made.
Every institutional investment plan has a different set of objectives. Because hedge funds are so eclectic and can accomplish so many different objectives, no two plans are trying to achieve the same things. So the first step at the planning stage is to ask what the mandated objectives are. If they are return-seeking, then investors should look to the HFR indices that offer higher expected returns. If the aims are more conservative, then more defensive strategies should be explored — relative value or market-neutral, for example.
With its layers of indices and sub-indices, the investable HFR universe caters for the full range of hedge-fund objectives, so allocations can be built with far greater precision.
Core and satellite
A key question with a hedge-fund allocation is the role of the benchmark. Is it to measure relative performance or does it define a minimum expected return? A combination of both? Given the significant return dispersion of individual hedge funds, an allocator could rationalize their ability to outperform the benchmark via the selection of a single fund. However, when you include to desire to allocate to other funds, in order to reduce concentration risk, style and strategies biases and/or to meet liquidity requirements, the allocators aggregate portfolio will often underperform on a risk adjusted basis. Why would this be the case? Often is as simple as the wide dispersion of returns. This means picking the “wrong” fund can have a material impact on the aggregate return of a more concentrated portfolio. By contrast, by investing directly in the HFR benchmarks, investors can put a floor on the minimum expected return and at the same time remove the risk of underperforming the benchmark.
This is where the “core/satellite” approach comes in. Investors can make their core allocation to the benchmark — whether that’s the main HFR 500 Index or one of the underlying sub-strategies — and then add some discrete high-conviction single fund exposures through a carefully curated fund selection process.
The beauty of this approach is that it significantly reduces the number of hedge funds that you need to own. You can focus your research efforts on only a few candidates. And by concentrating your “satellite” capital in those few funds, you can have the assurance that the “core” allocation has your back in case your chosen funds underperform.
This ability to focus on only a few funds is crucial. If you’re trying to balance alpha opportunities with appropriate diversification, you might end up with a portfolio of 30 individual hedge funds. That portfolio would take a huge amount of effort and money to assemble. And, inevitably, your first fund idea would be better than your twenty fifth.
It can be far more efficient, therefore, to achieve the diversification through a core allocation to an HFR index and concentrate all your alpha-seeking efforts on a much smaller pool of hedge funds. You could, for example, allocate 70% of your hedge-fund total to the index and use the remaining 30% for individual fund allocations.
And because the core allocation is already highly diversified, you can afford to have a more concentrated alpha allocation — in just a handful of individual hedge funds, perhaps. That’s because you have embedded diversification and put a floor under your portfolio by ensuring that your core will earn the policy benchmark in full.
So, instead of a long list of hedge funds in which you have dwindling conviction, your alpha-seeking satellite investment is concentrated in your top picks. This allows you to have much higher conviction in your hedge funds than if you were having to pick dozens for diversification purposes.
Rounding out and cash management
An allocation to the HFR indices can also be used as a means of gaining immediate diversification. This might arise, for example, when you have identified four or five alpha-generative hedge funds that you really like but want to round out the overall hedge-fund allocation with a passive allocation.
And then there’s the consideration of cash management. If you have a target hedge-fund allocation of 10% of your portfolio, but the actual allocation is just 6%, you can now close the gap straight away by putting the remaining funds in the benchmark. This is an important consideration for investors because it can remove the problem of under-allocation. A 10% allocation that’s persistently underfunded by four percentage points is likely to be reduced to 6% when the portfolio is reviewed. So the HFR indices can allow investors to set their targets and stick to them.
Tactical takesThe HFR indices also provide the potential for taking tactical views quickly and efficiently. It’s important to remember that sourcing hedge funds can be tricky. It’s painstaking work and immensely time-consuming.
At ASI, we have a 25-strong team devoted to researching hedge funds. But most institutions aren’t so well equipped. This can be frustrating if you see an opportunity in a particular hedge-fund strategy but don’t have the resources to commit to it. So, for example, you might identify potential in macro or event-driven strategies, but lack the means to go through with the sourcing, due diligence and board approval required to express that tactical view.
And even if you do go through with all of that, you might still get your manager selection wrong. If you’ve identified an opportunity in event-driven, you can’t be sure that the manager or managers you’ve selected will be able to capitalise on that opportunity. Given the risks associated with the individual managers, you might get your overall view right but its execution wrong.
By contrast, an investment in the HFR event-driven index can eliminate that risk at a stroke. If the opportunity plays out as you expect, you may benefit accordingly — and the manager risk will dissipate because of the 70 or so components of that index.
The same holds true for other strategies, including macro, distressed or long/short equity. By investing in the appropriate HFR index, you can eliminate manager risk altogether and express your tactical view in its purest form. The defensive characteristics of macro strategies, for example, may be better obtained through a broad index than through an individual fund that might have failed to position itself appropriately.
There are also real attractions in avoiding the manager-selection process altogether. Long/short equity is perhaps what most people think of when they think of hedge funds. There are more long/short managers than in any other hedge-fund category, but that means that you need a very large and experienced team to find the good ones. So, rather than meeting 25 managers who all describe their process in very similar terms, you can simply invest in all the investable long/short managers through the HFR long/short index. The savings in time, costs and risk are considerable — and you avoid the galling outcome of making the right call but getting the wrong manager.
Out of the shadows
All in all, the HFR indices look set to revolutionise hedge-fund allocations. Previously, this asset class has demanded doggedness and diligence, to say nothing of costs and time. But a full suite of investable indices takes an asset class that was often obscure and brings it out of the shadows and bang up to date.
By allowing investors to allocate quickly and efficiently to a whole range of hedge-fund strategies, the HFR indices offer huge potential for imaginative and innovative approaches to asset allocation. For institutions, managers and end-investors alike, the rise of the investible hedge-fund index is a welcome revolution.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
Diversification does not ensure a profit or protect against a loss in a declining market.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio. Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.