Markets Force Asset Allocation Changes—and Reexamination

(June 19, 2012) — Although alternatives may be the only asset class that can offer robust returns in today’s marketplace, hedge fund investing is no simple panacea and must be fully understood to be used effectively, a report and an interview released by consultancy bfinance demonstrate.

Sushil Wadhwani, a former member of the Bank of England’s monetary policy committee, asserts in the interview that pension funds and other institutional investors will be forced into alternatives because returns from fixed-income are so weak.

“The situation presses for a reduction of the portfolio’s exposure to fixed income,” says Wadhwani. “Pension funds which keep hedging liabilities by 100% and have low equity weightings are most unlikely to achieve the real rates of return in the long term they need. And it’s essentially because real yields on bonds are negative. For the moment, the dancing continues because the music hasn’t stopped yet, in the sense that even in 2011, investors had huge capital gains on bonds. It will only be a matter of time before the bond market turns and trustees get very itchy and want to switch allocation. Of course, when the herd starts moving, it might be too late.”

Wadhwani says that stocks are undervalued relative to fixed-income, although that is more a reflection of the weakness of bonds rather than the strength of stocks. As a result, he contends that pension funds “have no other choice but to increase their exposure to alternatives.” He also stresses that alternatives provide the best bulwark against possible inflation or deflation in the future: “it’s another one of those known unknowns, but one thing we do know is that if deflation happens your equities are not going to perform well.”

Yet alternatives are no silver bullet for institutional investors, as another report from bfinance authored by their Head of Alternatives Chris Jones illustrates. Jones looks at hedge funds strategies and advises investors considering them to resist looking at hedge funds too broadly.

“Investors need to target risk budgets and the particular types of hedge funds that will suit their objectives rather than just investing in hedge funds per se,” Jones writes. “Hedge fund strategies vary radically in terms of market exposure and risk. And contrary to a common belief, it is not true to say that a hedge fund investment is a good way to achieve portfolio diversification. Investors get expensive access to a different return stream and maybe a skill generated return stream, but not necessarily a diversifying return stream.”

He breaks down hedge fund strategies into four buckets: equity long/short, relative value, event driven, and trading. Equity long/short is the rather straightforward process of buying undervalued stocks and shorting those that are overvalued. Relative value centers on arbitraging across many different asset classes. Hedge funds using event driven-strategies seek to exploit market inefficiencies surrounding events like mergers or defaults. Finally, trading strategies are quantitatively driven, focusing on following trends and analyzing the global macro area.

“Overall hedge fund strategies present pros and cons just like any other area of investment,” concludes Jones. “Even when risks are considered, some hedge fund strategies can act as particularly good diversifiers and other hedge fund strategies, although less diversifying, can also add an enhancing return stream to the wider portfolio.”

To read the interview with Wadhwani, click here. To see the report by Jones, click here.