The role of hedge funds in an investment strategy

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1 Aon Hewitt Consulting Investment Consulting Practice The role of hedge funds in an investment strategy Risk. Reinsurance. Human Resources.

2 The role of hedge funds in an investment strategy A carefully constructed hedge fund allocation has the potential to deliver compelling sources of investment returns whilst offering genuine diversification benefits. However, we would highlight the importance of manager selection and portfolio construction in the hedge fund space in order for investors to benefit fully from their diversifying potential. What is a hedge fund? The NAPF describes a hedge fund as: A hedge fund is a highly active manager targeting absolute returns. The underlying philosophy of hedge fund investing is that the skill of the manager, rather than the return of the market, is the key determinant of how they will perform. This means they generally have a stronger focus on capital preservation than traditional equity strategies and seek to deliver positive returns regardless of the overriding market direction. Hedge funds are able to achieve their objectives by reducing or removing constraints associated with traditional investment strategies. In effect this means hedge funds have greater flexibility in their investment mandate, as well as the ability to be more sophisticated in the techniques and instruments they employ. % Exhibit 1: Up and down market returns January 1990-June % 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% HFRI Fund Weighted Composite -1.39% -3.52% 1.80% MSCI World USD 3.34% Short-selling is an example of such a constraint that is often removed for hedge fund managers. In comparison with a traditional long-only equity fund manager, who can only express an opinion that a stock is overvalued by not holding it in their portfolio, a long-short equity hedge fund manager is able to explicitly profit from this perceived overvaluation by selling the stock short and earning a return if the stock price falls. Source: Datastream, HFR Downmarket Upmarket While it can be seen that hedge funds do not tend to capture all of the upside of equity markets, they have offered significant downside protection compared with that of equity markets over the period since This increased sophistication and flexibility means hedge funds have the potential to offer investors a return stream which is less correlated to broad capital markets. A particularly attractive feature of this return stream is the ability to preserve value during periods of weak performance for traditional risky assets. Aon Hewitt The role of hedge funds in an investment strategy 2

3 The role of hedge funds in investment strategy A carefully constructed portfolio of hedge funds can play a number of vital roles in an investor s portfolio; including delivering absolute returns and providing diversification, thereby reducing the level of risk (volatility) at the overall portfolio level. This is supported by considering the most recent ten years of data. Exhibit 2 shows that the addition of a 20% allocation to hedge funds in a traditional equity and bond portfolio would have significantly reduced the volatility of an investor s portfolio without having a meaningfully negative impact on return. In Exhibit 2 the diamonds represent the risk and return profiles of a range of potential allocations to equities and bonds, represented by the MSCI World Index and the Barclays Global Aggregate Index, respectively. The triangles represent the risk and return profile of a portfolio that has allocated 20% to hedge funds, represented by the HFRI Fund Weighted Composite Index, by reducing the equity and bond allocations by 10% each. Exhibit 2: Risk vs. Return over 10 years to June % Annualised return % 6.5% 6.0% 5.5% 5.0% E 30%, B 50%, HF 20% E 0%, B 0%, HF 100% E 20%, B 60%, HF 20% E 100%, B 0%, HF 0% E 80%, B 0%, HF 20% E 70%, B 10%, HF 20% E 90%, B 10%, HF 0% E 80%, B 20%, HF 0% E 60%, B 20%, HF 20% E 70%, B 30%, HF 0% E 50%, B 30%, HF 20% E 60%, B 40%, HF 0% E 40%, B 40%, HF 20% E 50%, B 50%, HF 0% E 40%, B 60%, HF 0% E 30%, B 70%, HF 0% 4.5% E 10%, B 70%, HF 20% E 20%, B 80%, HF 0% 4.0% E 0%, B 80%, HF 20% E 10%, B 90%, HF 0% 3.5% E 0%, B 100%, HF 0% 3.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% Source: Datastream, HFR Annualised volatility % It can be seen that without exception the triangular portfolios are positioned to the left of the corresponding diamond portfolios, meaning they demonstrated similar return but for lower risk. Hedge funds are not a homogenous asset class, with managers employing many strategies and specialisations to generate returns. Naturally, the level of diversification from traditional asset classes provided by these strategies varies. Global macro strategies in particular have historically offered significant diversification. Aon Hewitt The role of hedge funds in an investment strategy 3

4 Exhibit 3 demonstrates the heterogeneity of performance by strategy and therefore the importance of strategy allocation and robust portfolio construction. Exhibit 3: Return vs Risk 10 years to June 2015 Annualised Return % 10% 8% 6% 4% 2% D 0 0 5% 10% 15% 20% Source: HFR, DataStream Hedge Funds I C J O Q N F G H M L P Annualised Standard deviation % E K B A Equities A MSCI World B S&P 500 C D E F G H I J K L M N O P Q BarCap Global Agg Hedged GBP ML 3 Month Treasury Bill BarCap Global HY HFRI FoF HFRI Fund Weighted HFRI Distressed HFRI Merger Arbitrage HFRI Eq. Market Neutral HFRI Emerging Markets HFRI Equity Hedge HFRI Event-Driven HFRI Macro HFRI Relative Value HFRI Fixed Income-Convertible Arbitrage HFRI Multi-Strategy Possible challenges to investing in hedge funds There are risks and obstacles to creating a diversified portfolio of hedge funds, some of the main ones are described below. Manager selection and portfolio construction Hedge funds success is largely built on the sophistication and flexibility of their approach which allows them to quickly take advantage of market opportunities as they arise, as well as to reduce their market exposure at times of stress. This means manager skill, or alpha, is a much larger component of hedge fund returns than other asset classes, such as equities and bonds, and consequently selecting a high quality manager is a more critical task than for other types of asset classes. The importance of strategy and manager selection is highlighted in Exhibit 4 which shows the dispersion among hedge fund manager returns in the HFRI Hedge Fund Indices over the most recent 12 months. Aon Hewitt The role of hedge funds in an investment strategy 4

5 Exhibit 4: Hedge fund performance dispersion by strategy 12 months to June Active commodities Activist Equity hedge Equity hedge short bias Return % Equity market neutral Event-driven Event-driven distressed/restructuring Event-driven merger-arbitage Macro Discretionary Macro Systematic Relative value Strategy Source: HFR The dark purple line represents the return of the median manager, with the top and bottom of the box representing the 25th and 75th percentile respectively. The length of the line indicates the 10th and 90th percentile. Reputational risk In our experience this tends to be one of the biggest obstacles for Trustees when considering an allocation to hedge funds. Hedge funds have had a significant amount of bad press, ranging from the Madoff scandal to being incorrectly accused of causing the financial crisis. This again underlines the importance of appropriate due diligence and manager selection. Transparency Some hedge fund strategies are extremely complex, Trustees should be comfortable with their understanding of the investment. Also, managers can be reluctant to reveal details of their investment process and portfolio positions as it may limit their competitive edge. Again, this underlines the importance of manager selection and due diligence. We insist on full transparency from managers and failure to provide it will result in an automatic Sell rating. Fees Hedge fund managers are normally remunerated by performance related fees. Typical management fees are 1-2% of invested assets and performance fees are typically 20% of realised returns. It is important to note that nearly all hedge fund managers report their performance on a net of fees basis, unlike many other asset management products. Market conditions In recent years, where extraordinary central bank policies have meant that a straightforward passive allocation to equity and bond markets would have delivered attractive, smooth and cheap returns, it would be easy for investors to become disenchanted with expensive looking hedge funds. We would argue that the diversification provided by these strategies is essential to the success of a long term investor s portfolio and that a carefully constructed hedge fund allocation has the potential to offer compelling sources of investment returns as well as downside protection. Owning a well-diversified hedge fund portfolio as part of a long term investment strategy is expected to enhance overall portfolio efficiency, net of all expenses in the long run. If you believe markets are looking fully valued at current levels then that may provide additional comfort around an entry point but it should not be the driver of the strategic allocation. Liquidity This refers to the risk of a fund not being able at all times to meet its obligations to investors, creditors and other counterparties. Complexities arise when, for example certain market segments dry up, making it difficult to dispose of assets when cash is needed. Most hedge fund products offer monthly or quarterly liquidity, subject to a certain notice period. They also may place restrictions on withdrawals during adverse market conditions known as gating. It is important that Trustees are clear about the terms of withdrawal and liquidity. Aon Hewitt The role of hedge funds in an investment strategy 5

6 Conclusion Despite news headlines over the past few years about poor performance, costs and major institutional investors such as Calpers turning their back on hedge funds, Aon Hewitt believes that a properly constructed hedge fund allocation has an important role to play in an investor s portfolio. This introductory paper demonstrates that the diversifying return stream that hedge funds have provided can have a significant positive impact on the risk-adjusted performance of an investor s portfolio both in terms of volatility reduction and downside protection. Given the wide variety of hedge fund strategies and significant dispersion in performance between managers within those strategies, robust portfolio construction and rigorous manager selection are essential in order for investors to ensure they maximise the impact of an allocation to hedge funds on their overall portfolio. Meet the experts John Belgrove Senior Partner, Aon Hewitt +44 (0) Chris Ullathorne Senior Consultant, Aon Hewitt +44 (0) About Aon Hewitt Aon Hewitt empowers organisations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organisational and personal performance and growth, navigate risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is a global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit: aonhewitt.com Follow Aon on Twitter: twitter.com/aon_plc Sign up for News Alerts: Aon Hewitt The role of hedge funds in an investment strategy 6

7 About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 69,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document. Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: The Aon Centre The Leadenhall Building 122 Leadenhall Street London EC3V 4AN Copyright 2015 Aon plc aon.com Risk. Reinsurance. Human Resources.

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