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Three Ways to Drastically Improve Portfolio Performance with Hedge Funds Based on Your Financial Goals

A Primer on Hedge Fund and Portfolio Performance

Evaluating hedge fund performance is challenging because it involves many different investment strategies employed by thousands of funds across a global $3.2 trillion industry. While many investors will analyze a previous track record to help determine which funds they should choose, that approach rarely leads to a great investment experience. As most investors know all too well, past portfolio performance is not necessarily indicative of future results.

Instead, investors are often best-served to consider one very basic question: what am I looking for when I invest in hedge funds? Ultimately, investors in hedge funds are seeking one of three things for their portfolio: capital preservation, diversification or return enhancement.

1) Capital Preservation and Portfolio Performance

The “capital preservation” objective typically leads investors towards larger, established funds that can invest in multiple markets, and can deploy capital across many different strategies around the globe. These funds can provide investors with capital protection while still delivering strong risk-adjusted returns over time. They tend to be less reliant on the general direction of bond or equity markets to drive their returns. Instead, they have more of an “all-weather” profile with the goal of generating consistent performance and lower volatility (or less drawdown risk).

You may also be interested in the Financial Poise webinar, “Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds”

Within traditional markets, fixed income often provides investors with this type of exposure. However, certain investors are becoming concerned about rising interest rates (when rates rise, bond prices fall, thus eliminating the intended benefit of protecting capital in fixed income). Instead, certain hedge funds can “fill the void” in terms of providing the preservation of capital role within a diversified portfolio.

 2) Portfolio Diversification Away from 60/40 Allocation

Typically, traditional investments in a combination of stocks and bonds provide sufficient diversification during normal market conditions. When investors have 60% of their portfolio in stocks and 40% in bonds, it is referred to as the “60/40” allocation approach.

The rationale is simple: equities tend to appreciate over time, as do bonds (albeit to a lesser extent). But, when equities decline, like they did in 2008, bonds represent a “flight-to-safety” exposure and function as a diversifier within the portfolio.

The rationale is simple: equities tend to appreciate over time, as do bonds (albeit to a lesser extent).

Today, investors are concerned about the possibility of equities declining while rates are rising, potentially leading to negative performance in both stock and bond markets. In that environment, investors may not be adequately diversified. Fortunately, there are certain portfolio performance strategies that act as diversifiers to a more traditional portfolio.

You may also be interested in, “The Fine Print for Investing in Hedge Funds”

Discretionary macro strategies have shown the lowest correlation to traditional markets over the past two decades. Macro funds typically invest in different markets based largely upon a manager developing a fundamental view of the macroeconomic environment and investing accordingly.

For example, a macro fund manager might think that the U.S. dollar is going to outperform the Japanese Yen, or that a certain commodity like gold or oil is likely to rise or fall in line with their expectations for global inflation.

These types of investments are very different than traditional stocks and bonds, and they offer investors an opportunity to introduce new exposures within a portfolio that is closer to 60% equities and 40% bonds, traditionally.

3) Flexibility for Return Enhancement

Historically, equity markets have been the “engine” of portfolio returns. However, there have been periods when equities have generated low (or even negative) portfolio performance over many years. Following the 10-year bull market in equities, some investors are concerned that a challenging environment is overdue for long-only equity investments.

However, there have been periods when equities have generated low (or even negative) portfolio performance over many years.

When it comes to hedge fund performance, there are three ways in which an investor can achieve enhanced returns, and all seek to take advantage of the flexibility that hedge funds have over long-only strategies:

  • The first is when the hedge fund uses a specialized focus, either geographic, sectoral or factor-based (e.g. value or small-cap) to generate returns from a long and short perspective. Portfolio returns over time will come from specific company exposures rather than broad market direction, driven by a dynamic portfolio construction and strong risk management.
  • Co-investments offer another way of enhancing returns, allowing investors to participate alongside a hedge fund in a single investment idea. Fund managers will occasionally have a specific “high conviction” investment in which they offer investors the opportunity to invest alongside the manager. These co-investments are typically within a single company or a specific theme that has a discrete time horizon (typically 1 to 2 years). This type of co-investment can benefit investors by charging lower fees than a typical fund investment.
  • Thirdly, investors seeking to enhance portfolio performance can focus on accessing smaller hedge funds that have historically delivered outperformance vs. larger peers. Strategically, these managers tend to focus on long/short equity and event-driven strategies and can invest in more “off-the-radar” securities that larger funds cannot readily access.

You may also be interested in, “What is a ‘Private Fund?’”

Considering the significant contribution to returns that equities have provided over the past decade, as well as the protection from bonds and the negative correlation between the two asset classes, investors may feel as though they are well-positioned. And from a return enhancement, capital preservation and portfolio diversification perspective, they are. However, as market volatility continues to increase, so does hedge fund performance, providing investors an opportunity to improve overall portfolio performance and quality over time.

 

About Joe Burns

Joseph Burns is Managing Director and Head of Hedge Fund Origination & Due Diligence at iCapital Network, where he is responsible for leading the single-manager analysis and developing multi-fund solutions for clients. Prior to joining iCapital, Joe was a Partner and Co-Chief Investment Officer at Pulse Capital Partners, responsible for manager sourcing, diligence, establishing portfolio…

Read Full Bio »   •   View all articles by Joe »

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