(August 15, 2013) – The myth of hedge funds being a homogenous group should be dismissed, and investors should recognise their potential as portfolio diversifiers, according to a new report from Commonfund.
In its latest whitepaper, the fiduciary manager tasked John Delano, Kristofer Kwait, and Justin Santana with investigating the role of hedge funds today. They found that even in periods where hedge funds underperform the broader market, they should still be considered valuable by investors as a diversifier for their portfolio.
The battle for hedge funds to win over hearts and minds will be a long one though. As the report outlined, there’s a number of misconceptions which continue to be believed, reflecting a “backlash against a perceived element of exclusivity”.
“One implicit assumption, for instance, is that the success of a hedge fund should be viewed as a standing bet on the direction of the S&P500 index. This would presume a hedge fund manager attempts to have long exposure to the equity market when it is going up and short when it is going down,” the report said.
“Another is that hedge fund managers ought to be perpetually ahead of the most widely-followed passive equity market index, given their elite and talented status…Actual hedge fund investing however, requires thoughtful, careful decision-making with significantly more context around strategies and their risk and return properties.”
The paper argues that by taking a broader look at the hedge fund universe and the correlations within it, it’s easy to see that the risk and return properties of a hedge fund allocation are not simply a function of the broad equity market.
While the number of funds that are correlated with the equity market has risen, so too has the number of uncorrelated hedge funds.
And despite some recent dire headlines, analysis of the HFRI Equity Hedge index has shown that the top half of the hedge fund universe averaged nearly 5% annual alpha generation , and the top 10% produced that level of alpha even when hedge funds as a whole were hitting historic lows in terms of returns.
The diversity element can also be found in hedge funds’ equity beta exposure, the report continued, driven by managers’ areas of specialisations and the different investment methods.
The report does not touch on price comparisons between those hedge funds it found to be most correlated and those with limited correlation, nor does it discuss the fees structures for those which performed well in the alpha generation study.
The trick for institutional investors is to pick the good value hedge funds from the bad. Manager selection is therefore more important than ever.
You can read the full report from Commonfund here.
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