NEPC: Redefining the Role of Hedge Funds

NEPC: Redefining the Role of HFs

Hedge funds are not dead. They’re just reinventing themselves, and investors are redefining the role they play in portfolios. Changing perceptions on how hedge funds may serve investors’ portfolios was among the discussions at NEPC’s annual conference, held in Boston on May 9 and 10.

Given the recent lackluster performance within the industry, some investors have exited the sector, while others are tweaking how they use hedge funds within the overall portfolio. In lieu of having a discrete allocation to the sector, some asset owners are now considering using the asset class more as a tool to better refine its exposure among other beta groups.

“Hedge funds are not an asset class,” Reino Ecklord, research consultant within the hedge fund practice at NEPC said at a panel discussion.. “Hedge funds really represent a variety of different strategies, a variety of different skill sets.”

By moving away from a dedicated allocation to hedge funds, investors can be more selective in opportunities within the space and the risk they are willing to take, Ecklord later expressed to CIO.

For example, some credit portfolios may include passive exchange traded futures exposure to high-yield bonds, long-only high-yield strategies, and private credit. Given the current environment, where spreads are tight and the potential downside to convexity exists, there may be value in a long-short hedge fund strategy, according to Ecklord.

“A credit long-short hedge fund might make sense within your credit portfolio; hopefully, giving you similar risk exposures but a more consistent high-return expectation,” he said.

Further, given the variety of strategies that exist, picking the right managers becomes evermore important in generating alpha. “You’re getting different experiences from different strategies from different market environments, so there is still some value in opportunistically allocating to these strategies,” Ecklord said after presenting the recent varied performance history of different hedge fund strategies.

“I don’t know if all of our clients someday will do it, but more and more are seeing the value of having a more opportunistically constructed portfolio,” he said.

Conversely, the challenge of opportunistically applying hedge funds strategies throughout the portfolio is that it may become difficult for investors to allocate specific benchmarks against performance, given it’s a more targeted strategy. Similarly, the opportunistic approach may also introduce peer risk by presenting challenges to fairly compare relative performance to other asset owners.

In terms of opportunities within the space, NEPC sees potential value within macro strategies targeting emerging markets, particularly as the drivers behind these economies vary from one another and from developed markets. “There are not a whole lot of managers worldwide that are good at emerging macro, but the ones that are good, we think there’s very good opportunity,” said Neil Sheth, partner, director of alternative research at NEPC, at a panel discussion.

Emerging market macro managers selected by NEPC have performed well over the past few years, according to Sheth. “They have the potential to continue to produce,” he said. The challenge with investing with EM managers is the capacity constraints and the limitations on fund sizes.

Other areas of potential opportunities include: niche strategies within structured credit with exposure to credit loan obligations, European merger activity, and long-short equity strategies in healthcare.

Of those investors who eliminated or lowered their hedge fund asset allocations, the shift in commitments have varied across public and private strategies. “You’re seeing some movement into private equity as that continues to offer a higher return versus the public market equivalent,” Ecklord said anecdotally.  Portfolios have also been rebalancing across more beta opportunities. For example, some investors may lower their hedge fund exposure and move towards emerging market equities.

Investors are not the only ones reinventing their perspective on hedge funds. Some of the funds themselves are changing their strategic approach and/or at least becoming slightly more transparent. Certain managers, for example, are becoming more vocal in their consideration of environmental, social and governance (ESG) factors and the value these factors play within risk frameworks and investment processes.

Other managers are sharing better details on qualitative aspects of their strategy, including what they are investing in, drivers behind their decisions, and aspects of their overall process.

“It is part of our process of assessing managers,” added Ecklord. “You can’t just look at performance and say they’ve done a good job and keep your fingers crossed.” NEPC tries to understand how managers approach the space and how their investment frameworks demonstrate potential consistency in performance.

“As they’re becoming a larger piece of the investment landscape, they’re going to be upheld to similar things that we expect from mutual funds or traditional active managers historically,” he said.