Asset Allocation

Stop Fiddling With Your Hedge Fund Strategy Allocation

<em>Investors who actively adjust their allocation strategy within a hedge fund portfolio to earn returns are making a foolish mistake, an article published by the CFA Institute has argued.</em>
Reported by Featured Author

(July 24, 2012) —“Don’t just do something, sit there” may be precisely the advice that hedge fund investors need to hear, according to an article published by the CFA Institute.

Hedge fund investors should actively rebalance their portfolio within certain bounds and avoid focusing on categories that outperform, contends the article, authored by Ted Seides, CFA. By doing so, investors can gain a leg up over their “performance-chasing” competitors. 

“Although the determination of a policy portfolio for hedge funds is an imprecise art, active rebalancing is a useful science that adds value and keeps behavioral biases in check,” advises Seides. “In absence of active rebalancing, allocations to hedge fund strategies inevitably drift away from espoused targets.” Consequently, investors should maintain clearly demarcated policy targets and not allow their portfolio to veer outside them.

Seides cautions that while anecdotal evidence supports so-called “momentum investing,” a shrewd investor can outperform peers by resisting the urge to invest in last year’s winners. “The odds are that one of last year’s underperformers, such as long–short equity, will take this year’s prize,” he explains. “Next year, we might look back through the rearview mirror and wonder if today’s case for global macro and trading strategies was little more than a behavioral bias–induced rationalization for performance-chasing behavior.”

At the end of the day, Seides asserts, tactical tilts in hedge fund allocation are simply speculative. Coupled with the cost of trading, active reallocation ensures that investors will incur high frictional costs for an unknowable benefit. This trade, he concludes, is axiomatically not worth it.

“An investor who is more aggressive in shifting around capital will eventually have an exciting story to tell, but if measured comprehensively is unlikely to add value through strategic tilts over time,” Seides writes. “It benefits those who are assessing allocator performance to insist on seeing data that manifests added value from policy target deviations before being seduced by anecdotal evidence.”

To read the paper in full, click here.