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Demystifying hedge funds: finding returns in volatile markets

Gareth Abley, Head of Alternative Strategies, MLC

 

 

 

Hedge funds are a widely known alternative investment that can potentially provide excellent diversification to a portfolio, and additional sources of returns. But rightly so, they're also known for their well-publicised 'blow-ups'. So investors tend to be polarised: they either love them or they hate them. Who's right? Are hedge funds the magic bullet that will solve all portfolio problems or should you steer clear? The answer is probably somewhere in-between. Gareth Abley explains.

 

The investor conundrum: high volatility, low returns, little diversification

Investors know all too well, we aren't in an ideal investment environment: shares are volatile, bond yields are low. And to make matters worse, the nature and reality of a typical portfolio means investors are taking on very high levels of undue risk.

 

The conventional balanced portfolio might have 65% invested in shares and 35% in bonds. However, few investors realise shares will contribute to around 94% of the risk of the portfolio, and bonds around 6%; that's simply because shares are a much more volatile asset class than bonds.

The conventional (un)balanced portfolio

Source: JANA Corporate Investment Services Limited, stylised illustration based on long-term expected returns.  

Investors typically diversify their portfolios across a range of asset classes including shares, bonds, property and cash. But with bond yields at very low levels and property trusts displaying similar characteristics to shares, sources of diversification and returns are harder to come by.

So how can investors reduce the risk of their portfolio, while generating enough growth?

The need for an alternative

'Alternatives' as an investment label is very broad. It includes things like venture capital, gold, timberlands, infrastructure and hedge funds.

Within the category of 'hedge funds', there are many different types of investments. And while it's a term that's regularly used, it doesn't actually tell us too much about the underlying strategies. There's a wide range of hedge fund strategies, from distressed debt, to short biased investing (where people try to make money from shares going down), to global macro investing (long/short), to fixed income, commodities, currencies, and the list goes on.  Whatever the type, the broad benefits are largely the same: these investments should provide an alternative source of returns and diversification to a traditional portfolio of shares and bonds.

Understanding the advantages and weaknesses

Aside from the diversification benefits they can provide, three of the key advantages of hedge funds are:

  1. Talent: Hedge funds tend to attract, in our view, the best investment talent. That's because they tend to pay very well and the manager has a lot of freedom to invest how and where they like.
  2. Personal interest: Managers generally have a large proportion of their personal wealth invested in the fund, which is a huge incentive to getting investment decisions right.
  3. Absolute returns: Importantly, unlike traditional funds, there's no hiding behind benchmarks. This means, regardless of the environment they face, hedge funds aim to deliver positive, absolute returns.

These advantages make hedge funds very attractive.  But it's important to be aware of their weaknesses:

  1. Correlation perception: Since August 2008 the broad hedge fund index, the Credit Suisse Dow Jones Hedge Fund Index, and the S&P 500 Index had a correlation of nearly 0.81. This is very high and means you wouldn't have achieved the diversification benefits you'd expect. However, individual funds did provide excellent diversification, with low correlation to shares. The MLC Low Correlation Strategy (an actively managed fund of hedge funds strategy) provided a correlation of just 0.04. This is the benefit of a specialist approach to researching and selecting hedge funds.
  2. Range in managers: The variation in quality of managers is enormous – you can have anything from two guys and a Bloomberg monitor, to extremely high-quality firms with incredible investment talent and risk management. And unsurprisingly, this can result in a huge dispersion of returns. Some hedge funds can make 50% -100% a year, some go bust. 
  3. High risk: There are many famous and many not-so-famous examples of hedge fund 'blow ups'. At the extreme, many will know Long Term Capital Management, who in 1998 nearly brought down the financial system. This is a risk that can be managed, and it's something to be cautious of.

The sheer breadth of choice of hedge funds means with deep research and analysis, you can combine very distinctive strategies that are uncorrelated to produce a risk-return efficient portfolio.

One way to access the benefits of hedge funds is through MLC's Low Correlation Strategy, which the MLC Wholesale Inflation Plus and MLC Wholesale Horizon portfolios2 invest in. We use this strategy within our multi-asset portfolios to deliver returns even when shares are doing poorly or drifting sideways.

If you have any questions or want further information about how our portfolios are positioned, please go to nabam.com.au, listen to our webinars, or follow us on LinkedIn.

 

1 Source: JANA Corporate Investment Services Limited, August 2008 to January 2016.

2 Excluding MLC Horizon 1 Bond Portfolio

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