By Georg Wessling – Many investors have been disappointed with their hedge fund returns over the past couple of years. This is justified to the extent that many hedge funds and funds of hedge funds have not achieved the targets promised to their investors. However, it should be noted that many investors have also failed to define realistic investment targets.
Harcourt Advisory has identified three groups of hedge fund strategies with distinct return and risk characteristics. The added value of the first group comes from alpha generated through superior security selection (selection alpha).
However, these strategies do not deliver pure alpha, as the alpha comes together with some (traditional) beta exposure (mainly to equity and credit markets). This means that these hedge funds, while delivering alpha, are not uncorrelated to an investor's traditional portfolio. The optimal use of this first group of hedge fund strategies is as a substitute for active long-only managers.
A second group of hedge fund strategies focuses on generating timely alpha. The success of these strategies depends on the correct timing of long and short exposure in equities, bonds, currencies and commodities.
Successful market timers tend to have a higher correlation to risky assets in up markets than in down markets. Therefore, hedge funds belonging to the second group are perfect diversifiers. Additionally, they can also be used as a tool for downside protection.
The special characteristic of the third group of hedge fund strategies is that they provide access to additional sources of return that we call risk premium or non-traditional beta. The premium is earned from bearing risks such as volatility risk (attached to an option), liquidity risk (typically attached to assets with limited or no public trading activity), or event risk (where the event can be a corporate event but also a natural catastrophe). These risk premiums come with fat tails and tend to show a higher correlation to risky assets in down markets than in up markets.
Defining the appropriate allocation to these three distinctive groups of hedge fund strategies is the heart of each successful hedge fund investment. It can be implemented either by building customised hedge funds portfolios or by investing in strategy-focused funds of hedge funds.
Harcourt Advisory supports its clients throughout the whole investment process. In the conception phase, the role that hedge funds are expected to play in the broader portfolio context is specified, and the appropriate investment universe as well as strategic allocation of the hedge fund portfolio is defined.
The goal of our selection is continuously to identify the best-in-class single hedge funds and funds of hedge funds per strategy. As such this phase does not comprise solely screening and due diligence, but also ongoing monitoring. The key success factors we have identified include the manager's focus and experience, processes and systems, fair treatment of investors, and portfolio fit.
Appropriate implementation enables added value through tactical decisions as well as the ability to control risk through proper allocations and avoidance of deficient orders. Finally, high quality reporting allows an investor to control the appropriateness of his hedge fund investment programme.
Georg Wessling is chief investment officer of Harcourt Investment Consulting