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14
I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Chart 14
Hedge
Funds
Directional
Macro
Absolute Return
Long/
Short
Event
Driven
Macro/
CTA
Distressed
Relative
Value
Arbitrage
Market
Neutral
Volatility
& Tail Risk
DIRECTIONALITY
LOW
HIGH
LIQUIDITY
HIGHLY LIQUID
ILLIQUID
Absolute Return
Performance during the global financial crisis revealed
two problems with this approach. First, investors could be
locked into investments if there was a mismatch between
the liquidity of the fund’s holdings and the fund’s liabilities in
terms of needing to cover investor redemptions. Many hedge
fund managers threw up gates or created side pockets that
excluded investors from redeeming capital at the height of the
crisis. This asset-to-liability mismatch prompted investors to
put much more focus on the relative liquidity of the hedge
fund strategies in their portfolios.
The second factor emerging from the crisis was that while
many investors thought that they had been pursuing alpha
through their hedge fund allocations, they found that in
some instances they were instead paying high fees for
what many considered to be alternative beta. That is,
managers were levering directional bets or taking advantage
of carry structures to capture the same type of market returns
that active long-only managers were pursuing in the core of
the portfolio.
Hedge Funds Allocations Begin to Be Broken Out
Across Multiple Types of Exposures
The result of these realizations was that many institutional
investors began to increasingly think about the hedge fund
industry not as a singular exposure, but as multiple types of
investmentswith varying degrees of liquidity and directionality.
This is illustrated in Chart 6.
While there is not a single standard approach to how investors
are breaking up the hedge fund space, we have tried to
represent the three most commonly mentioned categories
and show how they differ.
Directional hedge funds group those strategies that have an
underlying exposure to movements in the equity or credit
markets. Of key importance in evaluating this grouping of
strategies is understanding the net long or short position
of an individual manager. Not all long/short, event-driven,
or distressed funds have equal amounts of long and short
positions in their portfolio. Managers are typically considered
directional if their holdings are more than 60% net long or
short. At this level, the manager’s holdings are going to be
highly influenced by moves in the underlying market.
Moreover, as shown in Chart 6, there is a distinct difference in
the liquidity profile of long/short and event-driven managers
versus distressed managers. This category can thus be
subdivided into liquid and illiquid directional hedge funds.
In contrast, strategies that reside in the absolute return
bucket tend to have a much closer balance of long and short
positions in their portfolio. For the most part, these managers
run a net position of only 0% to 20% net long or short. As
such, they are seen as having low directionality, and they
generate returns by capturing relative pricing inefficiencies
between assets. Based on this profile, they are often discussed
as offering zero beta. The strategies in the absolute return
category offer a range of liquidity across market neutral,
arbitrage, and relative value approaches.
Chart 6: Emerging View with Multiple
Hedge Fund Categories
“ Clients initially start with hedge funds as a stand-alone
asset class. But they have slowly been moving hedge funds
into other categories. This is a gradual process but they are
disaggregating the risk more recently,”
– Alternatives Focused Consultant
“ There are so many of closet beta hedge funds that were
long-only biased funds that effectively were levered S&P.
Alpha is not simple outperformance; it is uncorrelated
outperformance,”
– Alternatives Focused Consultant & Fund of Fund
Source: Citi Prime Finance
“ A manager that was 50%-60% long would fall between the
cracks in our portfolio. That’s not really shorting and not
really tied to the benchmark. We probably wouldn’t take too
hard a look at them,”
– Endowment