Investors want more predicable returns from hedge funds, says Citi Private Bank’s Michael Stein

 Michael Stein, Citi

In the current climate, investors are looking for more defensive hedge fund strategies, capable of providing a predictable risk/return profile. 

That is the view of Michael Stein (pictured), Senior Portfolio Manager, Alternative Investments, Citi Private Bank, who states: “We are already seeing the benefits of these lower-risk funds in the current period, as markets respond to coronavirus. It’s a lot easier for us and the hedge fund managers we work with, to be accountable for the type of performance being delivered.”

This, he says, plays in to the type of strategies Citi Private Bank is shying away from; variable bias strategies, global macro strategies…anything that is less predictable in terms of what types of risks and directional exposure to the markets they have. “For our clients who invest in hedge funds for a certain purpose, if the manager is shifting their risk exposure frequently it becomes a lot less predictable and a lot more difficult to use in an asset allocation framework,” says Stein. 

From a portfolio perspective, these strategies with variable risk profiles, have been more challenging, not because the manager has necessarily done a poor job, but because it’s harder for Citi Private Bank to incorporate them into its implementation framework. 

“At Citi we continue to move away from evaluating hedge funds in isolation and toward understanding how they fit into a client’s multi-asset class portfolio,” explains Stein. “For example, equity long-short hedge funds with a net long bias need to make sense within a client’s equity allocation and present a compelling opportunity relative to other expressions of equity risk.

“Not all hedge funds are created equal. There is a risk spectrum. Some are higher risk and have a higher correlation to risk assets, some are more actively hedged, some are market neutral and some are completely diversified and defensive in nature. We make that really clear to our clients. Because there is a lot of confusion about the asset class and what hedge funds are trying to accomplish, it can be difficult to set the right expectations.

Hedge funds continue to be beneficial to how Citi Private Bank’s clients invest across their portfolio, using them as a tool to play certain themes and tap into broader opportunities within the private bank. They are also a way to access different styles of risk with higher quality or lower volatility, or to have a completely uncorrelated return stream that can really benefit a traditional stock and bond portfolio. 

CTAs fare well during major sell-offs

Short-term CTAs and very active traders fall into the category Citi Private Bank would shy away from, because in any given period, Stein says it might be difficult for its clients to understand what the drivers of performance are. If a client is investing in a certain strategy for diversification purposes, and they end up being down during a challenging period, it becomes hard to justify holding those types of funds. 

He says that short-term CTAs are relevant, but more for sophisticated clients, “so we have to select these types of strategies carefully”. 

“We haven’t completely exited the CTA space but we are cautious as to how we size those types of positions in client portfolios. It is one of the few strategies we do have confidence will work well when the market get more stressed.

“We think CTAs and traditional trend followers have gotten a bit of a bad rap because we just haven’t seen the types of trending markets they are designed to succeed in. When the behavioural nature of markets takes hold and there’s a major sell-off – as we’ve seen over the last couple of weeks – that is when you see outsized performance in CTAs.”

Last year was encouraging for the hedge fund industry. The HFRI Fund Weighted Composite index returned 10.4 per cent, its highest in a decade. Stein notes that some of its long/short equity funds, both generalists and sector specialists, delivered differentiated performance: “It showed through not only in the overall returns for 2019 but if you look at months like May and August, which were tough, we definitely saw short selling activity working well. We saw many managers protect capital or even generate positive returns in a month like May last year, and that has continued on into the early part of 2020.”

Citi Private Bank’s alternative investments group does not have exposure to any explicit short-selling funds but one of the important features of its research, and when conducting manager due diligence, is to determine whether an equity long/short manager is actually good at shorting, even in a rising market. He points to Q4 2018, in particular, as a period when some long/short equity managers exhibited their short selling value “in a more robust and visible way to our underlying clients”. 

“As part of an equity allocation you do want exposure to short selling strategies and the right managers capable of generating performance in a downturn,” he says. 

Hedge funds are a stronger use case

Much has been written and debated over the last five years as to whether hedge funds remain relevant to investors, and whether they have had to adjust their performance expectations. 

When asked his thoughts on this, Stein says it is not necessarily that their expectations have changed, “it’s more a case of us understanding what those expectations are in a much more robust way and then finding the right hedge fund solution”. 

“Everyone has their own individual portfolio objectives and it’s our job as their advisor to present them with a variety of hedge funds to build a solution that meets their needs. As we enter late cycle, I do think clients are moving more towards a defensive stance; that is when the concept of hedge funds becomes more interesting and the use case becomes broader,” argues Stein.

That’s really where the expectation comes in: investors have made money in their long-only portfolios and now the conversation becomes, ‘How do I stay invested but in a way that de-risks my portfolio?’  

“That’s what we are focused on,” says Stein. “Advising clients and helping to find ways for them to stay invested via a hedge fund portfolio approach without requiring them to exit the market at the first sign of volatility.”

He believes that investors are less inclined in today’s market to outsource not only the amount but also the direction of risk to a manager, given how quickly things can change. 

The inclination of many clients is to be defensive “and I think hedge funds are a good way to achieve that; moving from long-only funds to long/short equity funds, especially if there are more shorting opportunities, is a sensible way to de-risk”. 

Stein cites the liquid fixed income space as one example that looks interesting from an investment opportunity perspective, although he caveats that there are tail risks around liquidity and leverage, “which we watch closely as markets change. We do think fixed income is interesting but the strategies we favour tend to be more complex and are only suitable in the hands of the right client(s).”

Looking ahead in these uncertain times, the focus will be to continue unearthing interesting strategies to build value into clients’ portfolios. 

“When we find these, we also want to make sure we can offer them in a wide variety of structures and implementation tools, so that all of our global investors have access to them, regardless of their jurisdictional preferences and requirements,” concludes Stein. 

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