The search for yield is causing a rotation among institutional investors from classical investments to better yielding alternatives, such as hedge funds. Insurers such as AXA expect hundreds of billions in ultra low or negative yielding government bonds to be exchanged for other investments in the coming years.
Hedge funds are a rational option to avoid poorly performing assets in a responsible way. So says Karim Leguel, investment specialist at JP Morgan’s Multi-Manager Alternatives Fund. This EUR 1.9 billion fund offers exposure to a range of alternative strategies through a variety of hedge funds.
The negative connotation attached to the word “hedge fund” after 2008 seems to have largely disappeared. According to data and research firm Morningstar, 2020 was the best year for hedge funds since the aftermath of the financial crisis, with an 11.6 per cent gain in dollar terms for the broad HFRI Fund Weighted Composite Index. At the end of July 2021, the index stood at 9.2 per cent year-to-date.
Hedge fund volatility limited
According to Leguel, a major reason for the returning popularity is the fact that there is little left to be gained in fixed-income markets. In the “search for yield”, and the threat of an unexpectedly higher market interest rate (resulting in falling interest rates), everyone is looking for yield without taking too much risk. On average, hedge funds have a volatility of 4 to 5 percent. That is comparable to an average fixed-income index. We now see that institutions with 60 to 70 per cent exposure to fixed-income assets are moving into hedge funds without having to change their volatility profile.
According to Leguel, it is extremely rational to reallocate to alternative strategies. There is more than enough evidence of the benefits of alternative strategies on long-term portfolios.
“Especially for pension funds and insurers, alternative strategies are a sound solution to improve risk-adjusted returns due to the limited risk management adjustment, as hedge funds diversify their existing exposure to traditional assets such as equities and fixed income.”
The great advantage of these investment methods, according to Leguel, is that they are not correlated with traditional exposure to fixed-income products and equities. With an alternative strategy, an investor can build a portfolio with returns comparable to an equity portfolio, Leguel said. “Alternative strategies smooth the ride when all other markets become more erratic.”
Typically, the Multi-manager Alternatives fund uses a top-down sub-strategy review to determine the most favourable strategies for the next 12 months. The strategies are reviewed quarterly, but tactical reallocation also takes place when dislocations arise in different markets, Leguel said. Two strategies in particular are very attractive, the “long/short strategy” and “event driven investing”.
Long/Short Strategy
The former is a widely used hedge fund strategy, in which both long and short positions are taken simultaneously, without being market neutral. In this case, the return is sought in the spread between the two positions, Leguel explained.
“A long-only manager is 100 percent invested long. A long/short manager, for example, is 100 percent invested long and goes 70 percent short. In that case, there is 170 per cent exposure to the market, but only 30 per cent to a rising market. The ratio between the two positions can hedge the investment.”
“Shorting is really a unique skill. The maximum loss you can have on a long position is 100 per cent. The maximum loss on a short position is infinite, because a company can continue to rise in value. Managers with short positions must be much more active. It requires completely different skills to pick the right positions in that strategy.”
Event Driven Investing
The other now attractive strategy is “Event-driven investing”, which tries to anticipate price inefficiencies that may occur before or after a corporate event, such as an earnings call, bankruptcy, merger or acquisition. According to Leguel, this way of responding to the market ensures good returns without taking too much risk.
“When a company is acquired in a merger and acquisition procedure, we usually see that the price of the acquired company’s shares is close to the price of the acquiring company. Those two prices will never be exactly the same because of execution risks and regulatory risks.” Event-driven investors buy a position in the company to be acquired and simultaneously “short” the acquirer to capitalise on that (often small) price spread.
The profit, in a favourable case, is the spread, and the investor knows where the price of the acquired company will go if the deal goes wrong, namely the price before the acquisition. Price movements are not based on the market, but on regulatory outcomes and getting votes from shareholders, for example. Again, tracking those parameters requires different skills to those of a long-term investor.”