David Bell
The best definition of an absolute return is a very high likelihood of achieving a certain level of return regardless of the market environment.
The only financial instruments that provide absolute returns are fixed interest term deposits. It is therefore misleading to label hedge funds ‘absolute return funds’.
Increased flexibility does aid alpha opportunities, however, underlying market beta cannot be avoided within hedge funds. The challenge is to understand this to more readily appraise performance.
All investment products are a combination of market exposures and active return exposures.
The net sum of market exposures will always be 100 per cent — that is, market exposure cannot be created or destroyed.
For single market traditional products, there is usually only one market exposure, and for multi-sector traditional products, a range (all positive).
Hedge funds are a little more complex as they frequently involve techniques such as short-selling, leverage and the use of derivatives.
For example, a fund that is 200 per cent exposed to equities is leveraged and is short cash (that is, — 100 per cent exposed to cash). Note that the exposures still net to 100 per cent.
The investment outcome of a fund of hedge funds
Fund-of-funds (FoF) will tend to have relatively consistent market exposures because they are a diversified exposure to the biases of the underlying managers, which in aggregate changes little over time.
The biases will vary a little more if the FoF manager tactically allocates between different hedge fund strategies.
As a case study, assume a FoF is expected to have market exposure biases of 5 per cent high yield credit, 15 per cent global equity, and 80 per cent cash.
The key question is: what level of active returns is achievable? It is important to be realistic. Active returns are hard to find in a competitive market, albeit that a hedge fund manager has some structural advantages over traditional managers that may assist them if used properly.
Given the diversification a FoF targets, in our opinion, 2 per cent active return after fees is a good result, and 4 per cent active return after fees is a very good result.
This may not sound particularly exciting — but it is when compared to the active returns that have been achieved in traditional products such as Australian fixed interest and global shares (although reasonable levels of active returns have been achieved in Australian equities). It is also attractive when the low volatility of FoF performance is taken into account.
Table 1 (please see Money Mangement October 19, 2006 page 30) highlights what represents very good performance in that particular market environment.
It also highlights the problems with the concept of ‘absolute returns’ — if the concept was true, the number in each cell of the matrix would be the same.
The table assumes ‘very good’ active return performance. In reality, the level of active returns generated will vary, and sometimes will be negative.
It is important to understand the different styles of active returns and to recognise the difficult environments for generating active returns.
Portfolio construction using hedge funds
With all this necessary background, what then is the best way to incorporate hedge funds into a portfolio?
Classical portfolio construction techniques tend to take an ‘optimise then populate’ approach — the asset allocation is determined and then populated with products.
The problem is that the strategic asset allocation (SAA) is based on market exposures, whereas actual implementation via products creates both market exposures and alpha outcomes. The latter are an important contributor to risk and return, and need to be considered in a more robust manner.
An alternative approach would be a ‘product allocation’ approach that incorporates the active risk and return profile of each product into the allocation decision. In practice, this approach is too complex for the majority of portfolios.
A compromise is to group the portfolio into defensive and growth investment opportunities and compare the risk and returns.
For example, it is appropriate to compare our case study FoF (5 per cent high yield credit, 15 per cent global equities and 80 per cent cash) against other defensive investment opportunities, such as cash, bonds, mortgages and diversified credit.
The comparison would include the following questions:
1. What is the underlying asset class income of the opportunity?
2. What are the risks associated with the underlying market exposures?
3. What is the potential level of active returns?
4. What risks are associated with the active return exposure?
Analysed in a framework like this, a diversified FoF is an attractive investment because the active return profile is larger than that available in traditional defensive asset classes, so alpha is lowly correlated with returns of asset classes — a very valuable diversifier for portfolios.
The key proviso is recognising that a FoF will typically offer less liquidity than traditional defensive asset classes.
David Bell is responsible for all aspects of ColonialFirstState’s hedge fund business, including investment management, managing the hedge fund analysts and the relationship with the consultant, Harcourt Investment Consulting Plc. He has been with the hedge fund team since its inception. This paper is abridged from a paper first presented at the PortfolioConstruction Conference 2006, www.portfolioconstruction.com.au.
