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Alternative beta strategies can enhance HF allocations

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Over the last few years the FTSE 100 has gained 26 per cent, while the S&P 500 Index has gained approximately 65 per cent. The impact of quantitative easing has led to unparalleled growth in equity markets, to such an extent that hedge funds have largely lagged behind. This "raw" underperformance, in risk-adjusted terms, has led investors to question why they are invested in hedge funds. 

"In our opinion it's not just underperformance but a combination of underperformance and fees. This is leading investors to ask, "Why do I pay so much to receive so little?" says Nicolas Rousselet (pictured), Managing Director and Head of Hedge Funds at Unigestion. 

This is slightly misguided however. Investors have to understand what their ultimate objectives are. If they are looking to beat a strongly performing market, they should not be looking at hedge funds, whose aim is to generate non-correlated returns without the long-term support of the markets, but rather ultra-risky speculative levered directional funds.

Today's low rate environment has created a situation where hedge funds simply cannot expect to outrun the markets. Consequently, this magnifies the fees, creating a perfect storm of low performance and high costs. 

"Back in '05 and '06, when risk premia contracted, people used excess leverage and when funds collapsed in `08 investors were disappointed that they behaved like levered funds. Today, they don't behave like levered funds and this too is causing disappointment. It's quite ironic that even though investors learned their lessons from investing in levered funds the perception of hedge funds is still negative. Uncorrelated returns are harder to produce and this makes fees look bigger," says Rousselet. 

"To justify their fees, the manager has to have a demonstrable edge. Today, the proportion of truly talented managers is very small. They are rare, yet they are the ones who deserve the fees. Even if there were enough talented people, they would arbitrage themselves out so that only ultra-talented people would be able to have an edge."

But it is far from doom and gloom for hedge fund investors. There are ways to deal with the above issues. Take fees. Firms like Unigestion, whose mission is to uncover talented managers, are making strides in negotiating fees that are more aligned to the investor and which incentivise the manager to perform, not just sit on the management fee and gather assets.

"The point is, the fee should be paid by investors when the performance is good, not all the time. Transformation of fees is something we increasingly see. Managers who operate in the true spirit of what a hedge fund is are happy to look at this," says Rousselet.

Another key development is the emergence of factor investing and alternative beta products, which are helping investors better understand the true talent of a hedge fund manager. Some managers have, in the past, been no more than one-trick ponies says Rousselet. "Maybe they were a small-cap Japanese equity investor, shorting the Nikkei 225 and making large returns until the market turned. These were not uncorrelated hedge fund returns, it was a completely direction play. They were using a single factor (e.g. market capitalisation); that was the true driver of performance."

With alternative beta strategies, these one-trick ponies can be more readily identified and help investors become more selective; building a portfolio of pure hedge funds and more cost-effective alternative beta funds. 

"Depending on their objectives, investors can use alternative beta strategies, as well as accessing pure hedge fund talent too. There is a much wider continuum being created and that is a positive development," concludes Rousselet

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