Home ListingJanuary 13, 2014

The Fear of Dilution in Hedge Fund Portfolios

Towers Watson has warned hiring vast numbers of managers risks reducing alpha production and increasing fees.

Reported by Featured Author

(January 13, 2014) — Over-diversification from hiring too many managers could seriously undermine hedge fund portfolios and impair conviction, according to Towers Watson.

Investors add more managers to their portfolio to reduce volatility and increase complexity, but the effect could backfire once they reach a certain number, a report said.

“A portfolio of more than 20 to 25 managers begins to look more like an index—making it increasingly difficult in our minds to justify high fees,” the authors stated.

Alpha could be lost, Towers Watson added, and manager conviction could decline with too many managers. Instead, the consulting and asset management firm suggested investors consider altering the portfolio’s liquidity to reach the appropriate strategic allocation.

“The process of constructing a hedge fund portfolio is both an art and a science,” the report said. “While the flexibility managers have allows them the possibility of generating alpha, it also means that selecting the appropriate managers necessitates expert analysis and judgment.”

When allocating assets to managers after proper investment and operational due diligence, investors should ensure that their managers are uncorrelated to “achieve the type of portfolio volatility profile (i.e., low volatility with downside protection)” that capital providers typically seek from hedge funds, according to Towers Watson.

“One way is by allocating to managers that have different styles, even if they trade the same broad strategy classification,” the report said.

Asset owners could mix and match long and short managers as well as employ macro-managers who often provide returns that are both “uncorrelated with major markets” and positive during difficult market environments such as in 2008, said the UK-based firm.

Managers who can provide downside protection were strongly recommended.

The report also said managers’ historical returns should be analyzed alongside current asset classes, regions, sectors, and individual securities. Transparency should also serve as a key factor in hiring a manager.

“While back-tested returns are certainly useful for understanding the historical characteristics of a given manager’s portfolio, they are still historic data,” the report noted.

Additionally, it would be practical for asset owners to perform volatility and correlation stress tests to measure each manager’s correlation benefits and downside: “A review of how this aggregate portfolio would have behaved historically is then a valuable analysis, all while overlaying the analysis with qualitative judgment to account for things that are not easily measured (manager conviction, among other factors) before the final portfolio is determined.”