Alternative investments' value proposition
Published: 02 December 2016
One myth about modern hedge funds is that they are risky and volatile. Pension funds would often rather have steadier returns with lower volatility than a higher return with greater volatility. They invest in hedge funds because they are less risky than stocks. Equally, the industry's risk-adjusted returns are competitive with traditional asset classes such as stocks and bonds partly because those returns tend to be less volatile. Hedge funds also tend to perform better than most asset classes during crises and crashes.
Hedge funds invest significantly in risk-management, not least because they manage client money but capital is also invested by founders and employees. They have “skin in the game”, which aligns both the hedge funds’ and clients’ interests and is a powerful incentive to reduce losses as well as maximise investment profits. Many hedge fund strategies trade across multiple asset classes such as stocks, commodities, fixed income and foreign exchange.
Here are the main advantages hedge funds offer:
Hedge funds deliver risk-adjusted performance that provides investors with diversification benefits, even during difficult macro-economic environments — for example, the performance of some hedge fund strategies (notably managed futures and macro funds) can be counter-cyclical. To maximise diversification potential, investors will consider the correlation of returns of an individual hedge fund to their stock and bond holdings, including during times of market crises.
2. Risk-adjusted returns and volatility
Pension funds and other institutional investors in hedge funds would often rather have steadier returns with lower volatility than a higher return with greater volatility. This is why risk-adjusted returns are often as highly valued as the headline figures. Moreover, the hedge fund industry's risk-adjusted returns are competitive with traditional asset classes such as stocks and bonds partly because those returns tend to be less volatile.
Risk-adjusted returns are calculated by assessing the volatility of the returns using standard deviation. The lower the value of standard deviation, the lower the volatility.
3. Downside protection
Hedge funds are designed to provide greater protection against the large drawdowns or peak-to-trough losses that the traditional asset classes sometimes experience. The best hedge fund managers can maximise risk-adjusted returns and make this an integral part of their investment plan. Given the current environment of historically low interest rates, the use of hedge funds can help mitigate some risks if and when interest rates start to increase.
4. Flexible investment strategy
Hedge funds usually have a flexible investment strategy/ mandate and can move rapidly when opportunities appear. Depending on the strategy, they may apply leverage, invest in private securities, invest in real assets, actively trade derivative instruments, establish short positions, invest in structured products, and hold relatively concentrated positions. Hedge fund strategies are sometimes considered opportunistic because they may take sizeable positions for a short period of time. Traditional investment managers such as mutual funds, by contrast, tend to hold longer-term positions and generally prefer to spread their exposure across a market.
Hedge fund structures also allow them to develop customised products for their investors. For example, a pension plan may request that a hedge fund manager hold securities only in a specific market sector or request a reduction or increase in the level of leverage.
Hedge fund managers often aim to add value by specialising in a sector or market strategy. These managers seek to contribute above-market returns through the application of skill or knowledge of a narrow market or underlying strategy.
5. Low correlation
Since hedge funds are broad and varied in nature, hedge fund investments tend to exhibit a low correlation to other more traditional investments in the portfolio. The correlation between hedge funds and traditional markets has been thoroughly assessed in academic research with a broad consensus that the insertion of hedge funds into a diversified investment portfolio (of equities and bonds) could significantly improve its risk-return profile.
6. Customised tools
Institutional investors increasingly are moving away from the traditional 60% equities and 40% bonds portfolio structure, and using alternatives in general, and hedge funds in particular, as tools to customise their portfolios. Many investors allocate to hedge funds to help them meet their individual portfolio objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection.
7. New investment opportunities
Since the 2008 financial crisis, regulatory changes have forced traditional lenders and the proprietary trading desks of banks to step back from non-core activities. This has allowed hedge funds to fill that void – investing in projects from social housing to retailers.
Further readingAIMA/CAIA: The Way Ahead - Helping trustees navigate the hedge fund sector