Vanguard recently concluded that investors should carefully consider liquid alternatives and hedge funds.
Their research highlighted that they both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.
They suggest “that liquid alternatives are often viable options for investors who value the regulatory protections, ease of access, and lower costs they provide”, when compared to hedge funds.
Although hedge funds and liquid alternatives deliver valuable portfolio diversification benefits, “it is crucial that investors assess funds on a standalone basis, as the benefits from any alternative investment allocation will be dictated by the specific strategy of the manager(s).”
The most important feature in gaining the benefits of hedge funds and liquid alternatives is manager selection.
This reflects the wide dispersion of returns and investment approaches within the categories of hedge fund and liquid alternatives.
The Vanguard Report undertakes an extensive analysis and comparison of the performance and characteristics of hedge funds and liquid alternatives.
The comparison of hedge funds and liquid alternative is particularly useful to those new to the subject.
For the more technically advanced, there is an in-depth performance analysis comparing the drivers of performance between hedge funds and liquid alternative strategies. Vanguard ran a seven-factor model and a customised regression model to identify the drivers of returns.
Benefits of Hedge Funds and Liquid Alternatives
Vanguard’s analysis highlights that hedge funds and liquid alternatives provide diversification benefits to a traditional portfolio of equities and fixed income. As noted above, capturing these benefits is heavily reliant on manager selection.
It is important to note that the diversification benefits of the different hedge funds and liquid alternatives strategy types vary over time, they have time varying sensitivity to equity markets and fixed income.
It is also worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity markets and fixed income markets.
Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.
As evidenced in the Graph below provided by Mercer.
Blending Alternative investment strategies can smooth the ride
Vanguard note that an additional layer of portfolio diversification can be attained by combining different hedge funds and alternative strategies.
Vanguard’s analysis suggested global macro (including managed futures) and the market neutral strategies are the best diversifiers when combined with other hedge fund and liquid alternative strategies.
Their research highlighted that combining multi-strategy hedge fund and liquid alternatives with a few other strategy types provided additional portfolio diversification benefits.
Again they highlight the importance of undertaking fund-by-fund basis analysis to better capture these diversification benefits – i.e. manager selection is important
Framework for Manager Selection
Vanguard suggest a framework for manager selection
- Identify your investment objective for including hedge funds and liquid alternatives. Investors have an array of objectives, which may include return enhancement, portfolio diversification and risk reduction, and inflation protection.
- Before selecting a manager determine a suitable strategy type(s). This is undertaken in consideration of investment objective(s) and any constraints. This could take into consideration risk and fee budgets, tolerance for level of leverage, and operational implementation issues. Ideally you would want to identify a number of strategy types so as to gain the diversification benefits from having a blended investment solution.
- Undertake manager selection within the strategy types. Undertake research as to the benefits of a particular manager and their ability to consistently deliver return outcomes consistent with the overarching investment objectives within the strategy type.
- Maintain a policy of regular review and monitoring of the manager and strategies in meeting desired investment objectives.
Liquid Alternatives are often the Prudent Option
The report highlights that investors will place varying degrees of value on the relative benefits of hedge funds and liquid alternatives.
Vanguard note that liquid alternatives may provide valuable portfolio construction benefits for investors who are not interested in undertaking the additional due diligence required for, or paying the costs associated with, investing in hedge funds.
They conclude that liquid alternatives maybe a viable option. Compared to hedge funds liquid alternative often have:
- Lower fee structure that are easier to understand;
- Greater transparency of underlying holdings; and
- Greater liquidity i.e. easier access to getting your money back.
The Vanguard analysis reveals that hedge funds have performed better than liquid alternatives. They have also performed better on a risk adjusted basis.
However, the dispersion of returns between hedge fund managers is greater.
Vanguard undertook extensive performance analysis of hedge funds and liquid alternative returns, using factor analysis. Vanguard ran a seven-factor model and a customised regression model.
This analysis highlighted that liquid alternatives have more consistent factor exposures than hedge funds. Their returns are driven more by market factors such as value, momentum, low volatility, credit, quality, and liquidity.
Different factors drove the returns of different liquid alternative strategies – thus the diversification benefits of combining different strategy types.
Conversely, hedge funds are driven more by manager skill, returns are less sensitive to market factor returns.
Liquid alternatives provide an exposure to more “generic” hedge fund strategies – “hedge fund beta” exposures that have been found to be relatively stable over time. The market sensitivities vary across the different strategy types.
Investing in hedge funds, provides access to more unique return sources (alpha). Albeit this is harder to identify. Therefore, manager selection is even more important, given the larger dispersion of returns amongst hedge fund strategies and managers.
However, both the hedge fund alpha and the liquid alternative beta can provide diversification benefits to a traditional portfolio. Therefore, both can play a role in a portfolio.
Individual preferences and constraints will largely drive allocations to each.
Appropriate due diligence and focus on returns after fees will increase the likelihood of capturing the portfolio diversification benefits.
Manager selection is key.
Stay safe and healthy.
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Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.