The Alternative Investment Management Association has published a new report on the role of hedge funds in the portfolio of institutional investors.
The idea is to show, in the words of a foreword by Mark Anson, “how hedge funds can adapt and diversify portfolios of … endowments and foundations, pension funds, insurance companies, private family offices and sovereign wealth funds,” in a way that reflects how the industry “has grown and matured over the last 15 years” since the bursting of the dotcom bubble.
Hedge funds outperformed in the tricky environment of 2000, and that fact did their marketing for them. Institutions now invest in hedge funds for a combination of three reasons: access to non-traditional investment strategies; the diversification benefits of a presence on both the long and the short side of a market; the benefit of the skills of access managers who work outside of the stodgy long-only world.
A sample pairs trade
As an example of what hedge funds bring to the portfolio of institutions, the AIMA paper looks closely at a particular pairs trade. An investor may believe that Coca-Cola has a decisive advantage over Pepsi in the Cola wars. But if he expresses this confidence by a long-only investment in Coke he runs the risk that consumers will tire of colas in general. Betting on the ‘right horse’ won’t help if horses in general go out of style, and cougar racing becomes the hot new pastime even in Kentucky.
A hedge fund manager of course can express confidence in Coke over Pepsi while protecting his position from industry wide risk. He can go long on Coke and short on Pepsi. This means the bet is solely on the intra-industry difference, not on the continued success of the cola industry as a whole.
The paper runs through some sample arithmetic. If Coke (NYSE:KO) is selling for $100 a share and Pepsico (NYSE: PEP) for $50 a share, then the market neutral position is achieved by going long on one of the former for every two shares of the latter shorted. Assume consumers switch en masse to fruit juices, so that KO falls 20% and PEP falls $50. Our hypothetical manager will lose $20 on the KO trade but gain $50 on the PEP trade, coming out of the fruit-juice switch up $30. Why? Because he was right. Despite the negative sign on both sides, KO did better than PEP.
Equity market neutral funds go far beyond simple pairs trades. Still, for reasons that this example illustrates, equity market neutral funds, the paper says, have “demonstrated their resilience over the past 20 years, posting steady long-term risk-adjusted returns.” Relatedly, they prove resilient against sudden changes in liquidity, too. Liquidity risk exists, but is less acute here than it is in many other sorts of fund.
Cluster Analysis
That is familiar enough: as is much else that the new paper says about the hedge fund strategies to which institutions rationally want access/exposure. What is somewhat more novel is the discussion of “cluster analysis” as a way of measuring hedge fund performance.
Hedge funds are clustered together for this purpose on the basis of both quantitative and qualitative information. In qualitative terms, clusters can be defined by strategy, asset class, regional mandate, etc. In quantitative terms, they can be defined by annualized return, return autocorrelation, annualized standard deviation, etc.
After all their clustering is done, the authors of this paper have distinguished between two very broad families of hedge funds, regarding from the perspective of institutional investors: the substitutes and the diversifiers. The family of “substitutes” includes hedge funds that exhibit behavior similar to equity risk factors over the complete business cycle. The family of “diversifiers” on the other hand zigs where the equity markets zag. Each of these families is a cluster-of-clusters, so to speak.
Global macro funds, and managed futures, for example, are in the family of diversifiers. These two sorts of fund have, historically, the “most balanced return profile experiencing lower drawdowns than many other investment strategies” with a “relatively unique ability to earn profits when equity and bond prices are declining.”
Emerging markets hedge funds, on the other hand, belong to the “substitutes” family, even though historically they originated from within the global macro camp.
The paper is a contribution to an ongoing series on helping trustees “navigate the hedge fund sector.” It will surely advance that navigational cause.
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