What’s Trending – Allocator Perspectives on Investment Strategies – Q4:2019

Blended returns from multi-manager portfolios have caused many investors to rethink their approach to hedge fund investing, leading some to change the way they incorporate hedge funds in their portfolios. How are investors changing their use of hedge funds? Which strategies are experiencing the biggest increase in demand? Which managers do investors believe have the greatest edge in today’s markets?

THE BIG RETHINK: HEDGE FUNDS AND HOW TO USE THEM

Historically, institutional and private wealth investors have used multi-manager hedge fund allocations to diversify away from their equity and credit beta exposures. However, these hedge fund allocations have delivered varied results over time, which has caused investors to rethink what they are trying to achieve with hedge funds and how to most effectively use them. As a result, many investors are taking a closer look at which individual strategies can help them achieve their new objectives.

AREAS OF FOCUS

Areas of focus for institutional and private wealth investors include fresh approaches to incorporating hedge funds in portfolios, changing demand for investment strategies, and evolving views on which managers have the greatest advantages in today’s market. The views expressed herein were shared by different endowments and foundations, insurance companies, investment consultants, fund-of-funds, single family offices, and wealth management firms.

• Fresh Approaches to Incorporating Hedge Funds in Portfolios:
  • Defining a True Diversifier: The initial reason many investors used hedge funds was to diversify away from the volatility that comes with equity and credit beta exposures. With that said, during years where volatility spiked, many hedge funds moved in similar directions with the equity and credit markets.

    As a result, investors have been rethinking what constitutes a true diversifier. Some consider a true diversifier to be a strategy that behaves independent from U.S. equity and credit market movements. When equity and credit markets sell-off, these diversifier strategies can generate returns that are flat-to-positive.

• New Tactics for Portfolio Construction: Baskets of hedge funds have generated varied results over time. In order to achieve different outcomes, investors have been exploring the following approaches:
  • Embracing Concentration: Some investors are moving away from more diversified portfolios of 25 to 40 hedge funds and shifting to more concentrated portfolios of 8 to 12 funds. Considerations with running concentrated portfolios include the need for advanced manager selection skills and increased risk of correlations between the managers.
  • Pairing Beta-Plus and Diversifier Strategies Together: Other investors are shifting away from having stand-alone hedge fund allocations and instead using individual diversifier strategies to offset specific long exposure. For example, some investors are reorganizing their equity portfolios to include long-only strategies and long/short strategies in order to more effectively measure the diversification benefits of long/short strategies against beta. This is the main reason that investors prefer long/short equity strategies with lower net exposures.
  • Using Hedge Funds for Beta-Plus: Many investors have the view that shorting has become more challenging with the rise of ETFs and quantitative trading. This has led to an increase in investors looking at long-only hedge fund strategies that can outperform equity and credit beta over time.
  • Refining Asset Allocation Methodology: Most allocators use an asset allocation methodology when thinking about manager selection. This includes layers of investment strategy categorizations and sub-categorizations, weighting percentages for each, and thoughts on behavioral objectives. Some allocators have refined this traditional approach by prioritizing total return potential and a manager’s differentiated experience used to achieve those returns. (These investors do weight individual manager-allocations, but weightings are a function of total strategy risk.)
• Changing Demand for Investment Strategies: Most hedge funds generate returns by investing in public markets and trading around price dispersion. As public markets have become more crowded with hedge fund trading, spreads between assets have tightened, which has made achieving sizable returns from trading more challenging. As a result, investors have been rethinking which hedge fund strategies have the greatest return potential in today’s market and have shared the following thoughts:
  • Liquidity Strategies: Some investors share a view that hedge funds have the most opportunity when they serve as liquidity providers to the market. When market dislocations occur (often caused by market structure or cyclical changes), by serving as liquidity providers, hedge funds can invest in deep-value opportunities and then potentially sell those investments at significant gains over time.
  • Niche Strategies: Some investors have the perspective that trading equity and credit markets are commoditized skill sets. These investors prefer strategies that require expertise that is less common, such as trading electricity futures or municipal-issued carbon offset credits.
  • Strategies with Asymmetric Return Profiles: Some investors actively look for sector-focused strategies with asymmetric risk/return profiles. Sector-focused strategies are generally more volatile. Over a multi-year period, they often experience large performance gains, followed by large performance drawdowns, followed by large performance increases again. Interested investors look for strategies that have recently experienced large drawdowns and are poised to bounce back.
  • Single-Theme Strategies: Other investors share a view that single-theme hedge funds, including those focused on a single industry’s consolidation, have the best opportunity to generate returns. Their focus on a single industry allows managers to have a deeper understanding of the investible universe, capital structures of companies within that universe, and the securities with the highest return potential.
  • Concentrated Strategies with Less Trading: A number of investors prefer fundamental strategies with concentrated portfolios of 10 to 35 issuers, which are held over longer periods of time. These strategies have the potential to outperform shorter-term diversified strategies, which come with higher trading expenses, less favorable capital gains tax treatment, and less volatility.
• Evolving Views on Which Managers have the Greatest Advantages in Today’s Market: Investors have different views on which managers have the most competitive advantages in today’s market. They have shared the following thoughts:
  • Execution Advantages: Since larger managers generate more fee revenue, they have more ability to continually upgrade their trading capabilities. Since smaller managers may not be able to afford these same upgrades, larger managers may have an advantage with trade execution.
  • Quantitative Trading Capabilities: Some investors believe that in order to remain competitive in electronic markets, discretionary managers must use quantitative methods to execute trades. Managers who deprioritize the impact quantitative trading has on price fluctuations may be less effective with their trading and may not remain competitive over the long-term.
  • Evolving with the Market: A number of investors believe that the most competitive managers have the ability to successfully evolve and remain competitive over multiple decades and market cycles. Their resilience shows an edge with research, a lack of reliance on backward-looking data, and a rigorous risk management approach.

CONCLUSION

When individual hedge funds fill a specific portfolio need, measuring their ability to accomplish that need may be easier than measuring the benefits of a stand-alone multi-manager allocation. As long as investors continue rethinking their use of hedge funds, there will be new ways to incorporate hedge funds in portfolios, new preferences for investment strategies, and new thoughts on which managers have the greatest competitive advantages in the market.

Interested in learning more? Contact our Prime Services’ Capital Introductions team:

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BNY Mellon's Pershing

BNY Mellon’s Pershing and its affiliates provide a comprehensive network of global financial business solutions to advisors, broker-dealers, family offices, hedge fund and ’40 Act fund managers, registered investment advisor firms and wealth managers. Many of the world’s most sophisticated and successful financial services firms rely on Pershing for clearing and custody; investment, wealth and retirement solutions; technology and enterprise data management; trading services; prime brokerage and business consulting.

Pershing helps clients improve profitability and drive growth, create capacity and efficiency, attract and retain talent, and manage risk and regulation. With a network of offices worldwide, Pershing provides business-to-business solutions to clients representing approximately 7 million investor accounts globally. Pershing LLC (member FINRA, NYSE, SIPC) is a BNY Mellon company.