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The Six New Commandments of Hedge Fund Investing

Since 2008, the institutional playbook for hedge fund investing has been straightforward:

   -    Build a diversified portfolio of large, single manager funds diversified across four strategies:  equity long/short, event-driven, relative value and macro/CTA;

   -    Favour funds with recognizable brand name, sizable pools of assets under management, a robust investment process and a track record of at least 3-5 years. 

The limitations of this model are now apparent across the institutional world. Management and incentive fees remain stubbornly high, despite mediocre performance. Consequently, almost all alpha generated by hedge funds has inured to the benefit of managers, not clients. 

Institutions aren’t the only parties buckling under this investment ethos. Hedge funds, nervous about being dropped from portfolios because they don’t fit a neat style or sector box, are afraid to deviate from their strategies, which has been an important source of alpha in the past. Temporary large drawdowns used to be accepted as a normal part of an investment cycle; today, patience for drawdowns, no matter how temporary, is low. Given that fees are high and investors are quick to pull money during drawdowns, many hedge funds are limiting their risk taking to preserve business value.

The result of this is that hedge funds are in a limited position to generate the returns needed to overcome high fees. Institutions and hedge funds both see that this isn’t a sustainable model. In response, a new way of thinking has taken root among sophisticated investors. The new paradigm – grounded in six core principles - holds the promise of better returns, lower fees and a proper re-alignment of incentives:

  1. Understand that the underlying opportunity set drives performance.
    A portfolio split across typical strategies is unlikely to capture a constantly evolving market opportunity set. These days, alpha is generated more often in esoteric or temporarily mispriced markets. Pure value or growth managers won’t have the flexibility to find these opportunities and generate the alpha needed to justify their fees.
  2. Structure fees appropriate to the investment strategy
    Few will argue that the 2/20 fee structure is justifiable for most hedge funds.  The new rules of fees include: Performance fees are only charged above an appropriate hurdle rate; these fees should be paid over multiple years; most importantly, management fees should decline as fund assets grow so manager compensation remains tied to outperformance, not size.

  3. Expand the universe of strategies and structures to achieve the same goal
    Typical hedge fund vehicles aren’t the only way to get the job done.  An allocator who seeks exposure to managed futures, for instance, can choose between potentially favourable structures like UCITS/mutual funds, OTC swaps and managed accounts. 

  4. Embrace lower cost alternatives when feasible
    Unbeknownst to many institutions, strategic fee reduction is another source of alpha. For example: replication-based and risk premia strategies offer much of the upside of actual hedge funds with just a fraction of the fees. There are also low cost multi-asset class funds can deliver results similar to that of a diversified portfolio of macro hedge funds. Knowing which high- or low-cost option to select requires a rigorous and honest examination of when higher fees are justified and when they are not.

  5. Employ liquidity as both an offensive and defensive weapon
    Liquidity can be used not only to reduce risk, but also to capitalize on market dislocations.  Allocators should be prepared to re-allocate aggressively when opportunities emerge because, as Warren Buffett eloquently puts it, “every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold.”

  6. Rigorously examine biases
    Allocation is filled with structural and behaviorial biases.  For example, recency bias leads to a high allocation to funds coming off a hot streak; loss aversion may be economically rational due to career or business risk, but can result in a misallocation of capital; and anchoring can make modest savings appear attractive to relative to headline fees, even if the reduced fees are still uneconomically high. 

The logical outcome of this shift in allocation, we believe, is a move to core-satellite portfolios. The ‘core’ of the new institutional portfolio consists of liquid allocations to replication or similar strategies that can improve returns through fee disintermediation, lower total expense ratios and enhance portfolio flexibility through daily liquidity. In turn, allocations to higher fee funds make up the ‘satellite’; these are concentrated investments in more esoteric and illiquid strategies that may suffer brief, sudden drawdowns, but ultimately produce high alpha.

Since replication-based strategies provide synthetic diversification and minimize certain fat tail risks, this should enable allocators to take more risk with satellite investments.  A better balance between truly liquid and illiquid investments should position allocators to capitalize on market dislocations, a very important source of alpha over time.  These new rules for hedge fund investing promise to make the next decade far more abundant than the last.


Andrew Beer is Managing Member of Dynamic Beta Investments


The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher, The Sortino Group

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