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I
Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Since periods of extreme economic stress also correspond to
increased periods of market volatility, managers focused on
protecting investors from these types of exposures are also
grouped in this risk category. Given the severity of the 2008
move, many investors began to express an interest in one type
of volatility protection in particular: tail-risk hedging.
Managers pursuing this type of strategy have an unusual
profile; during most years they pursue neutral investment
programs that result in returns that tend to be close to 0%,
but in periods when volatility spikes, their out-of-the-money
puts or swaptions will jump in value and offer high returns to
offset losses elsewhere in the portfolio.
The challenge with tail-risk hedging funds is that they usually
end up as a cost to the portfolio and their benefit is evident
only in extremely rare instances. For this reason, many
investors are either looking at managers that have funds
capable of generating returns based on more varied types of
market volatility or they are opting to handle tail-risk hedging
on their own.
Some Investors Pursue Their Own Tail Risk Hedging
or Tactical Asset Allocation (TAA)
To avoid the costs associated with tail risk or volatility hedging
funds, some investors have built out their own programs to
manage these exposures. This is often accomplished through
a dedicated put- or swaps-buying regime. Because of the cost
of this approach, some investors are instead looking to handle
this protection in one of three other ways: tactical asset
allocation, portfolio hedging, or the use of custom overlays.
Employing a TAA approach requires active management from
the investment team; it generally entails moving allocations
between equity and fixed-income allocations and using
futures contracts to balance the overall portfolio. Trades are
placed at somewhat frequent intervals, up to several a week.
This approach is typically employed by investment teams
that have prior sell-side or buy-side trading expertise and are
comfortable managing an active book.
Some institutional investors are seeking a structured
exposure that gives them protection across a large swath
of their portfolio. These structured solutions often feature
custom swaptions that provide the buyer the right, (but not
the obligation) to enter into a swap position that broadly
hedges the portfolio. In addition, many investors use collars
or other structures to employ protection against large losses
while giving up some potential gains.
Finally, there is an emerging group of institutional investors
that work with a hedge fund manager to create bespoke
overlay strategies. These managers will review the entire
portfolio and craft a custom investment product, often
using liquid currency and other macro-themed instruments.
Many times, pensions have tail risk on their liabilities
via rates, so employing an overlay program can provide
downside protection.
It’s important to note that the investment teams employing
these approaches tend to be among the most sophisticated
institutional investors and have large, dedicated groups looking
across both the long-only and hedge fund portfolios. These
teams tend to be more experienced and better compensated
than the average institutional allocator. The quest for talent to
start and grow these programs can be quite challenging. An
“ The way we’ve done tail-risk hedging is more subtle. We’ve
done volatility management by shifting our asset class
allocation,”
– Endowment
“ Tail-risk hedging is an important concept to us and we’re
putting that concept into place in the portfolio in our own
way. We’re not really looking at the tail-risk funds. We’re
applying tail risk across the entire portfolio,”
– US Corporate Pension
“ People are not looking at tail risk per se as an allocation
because of the costs involved. Rather than a dedicated
put-buying program which is a losing proposition,
they are instead looking to get long volatility. Volatility is
the new gold,”
– <$1 Billion AUM Hedge Fund
“ We see real demand for an off-the-shelf tail-risk product
with a lower entry point than is currently offered from
the very large managers. It will really appeal to the most
sophisticated large institutional investors. It was created
through reverse inquiries,”
– $5-$10 Billion AUM Hedge Fund
“ Investors do not need to pay the premium for these
backward-looking tail-risk funds. The vast majority of tail-
risk hedging funds offer a deeply flawed strategy,”
– Long-Only and Alternatives Consultant