Guidelines and Constraints

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1 Insights December 2013 Hedge Fund Portfolio Construction Key Considerations The process of constructing a hedge fund portfolio is both an art and a science. While the flexibility managers have allows them the possibility of generating alpha, it also means that selecting the appropriate managers necessitates expert analysis and judgment. The goal of this paper is to focus on hedge fund portfolio construction, with less of an emphasis on how to identify the best managers through due diligence. * Below, we discuss what we believe are several of the ingredients for success. Manager Universe A universe of high-conviction hedge funds across a variety of strategies is the starting point for any hedge fund portfolio. It is paramount to have a dedicated and well-resourced hedge fund research team to conduct the bottom-up manager due diligence. Our experience in building and managing portfolios for clients supports the belief that hedge fund manager selection insight comes only through primary research. In addition to investment due diligence, conducting operational due diligence prior to approving a manager may identify important risks. Operational due diligence is the part of the process where the hedge fund business is reviewed to assess whether the proper controls, resources and procedures are in place to adequately support investment and trading activities. Finally, an analysis of a hedge fund manager should include a review of the manager s capacity (i.e., whether the manager with its management style is able to take in additional assets without impeding its ability to invest). Even region-specific constraints such as the ability of a manager to take ERISA-classified assets may need to be examined. Guidelines and Constraints The starting point for constructing a hedge fund portfolio from this universe of high-conviction managers is establishing appropriate investment guidelines and constraints. Often, these will be clientspecific, expressing risk tolerances and preferences framed by overall portfolio objectives that typically include: Return and volatility targets. For example, a typical target return for a diversified hedge fund portfolio might be LIBOR + 4% to 6% annualized, with annualized volatility of 4% to 8%. Strategy allocations. Investors may want to limit their allocations to certain strategies or weight others higher. Exposure guidelines. Such guidelines are put in place to minimize the risk of capturing market exposures that are redundant with other parts of a portfolio. Often, investors are sensitive to equity, credit or other risk premia across their asset allocation and look to hedge funds as a source of diversified returns. Liquidity guidelines. Investors will have different tolerances for liquidity and will typically express this with reference to proportions of the portfolio that either need to be realizable in a specified period of time, or a maximum proportion that can be locked up for a given period of time, or both. Maximum percentage allocations to any one manager to mitigate manager-specific risk. This can be based on a simple percentage of capital allocated or on the downside risk of the manager. Drawdown or stress period management. It is informative to see how the portfolio would have behaved in prior stress periods, as well as to make projections on how it could behave in future periods, making certain assumptions. It is paramount to have a dedicated and wellresourced hedge fund research team to conduct the bottom-up manager due diligence. * For additional content related to our views on hedge fund fees, terms, alpha assessment and other interesting topics, please reference our publication: Hedge Fund Investing Opportunities and Challenges, available at.

2 FX hedging policy and choice-of-fund share class. For instance, while most hedge funds offer U.S.- dollar share classes, for clients outside the U.S., it may be important to have a share class denominated in their home currencies. While these hedge fund portfolio constraints are fairly common, there are still many others that are possible. Diversity Versus Dilution There is a balance between achieving diversity in a hedge fund portfolio and having too many managers in the portfolio so that it dilutes any meaningful benefit from strong manager selection reflected in returns. We would argue that over-diversification (dilution) is one of the most common mistakes that investors make when building a hedge fund portfolio, adding complexity while debasing conviction. How prevalent is hedge-fund-of-fund dilution today? And what are the implications for investors? Today, most hedge funds of funds have 30 to 50 (or more) managers, resulting in alpha being diluted or diversified away, eroding opportunity for the investor. Consider Figure 1, which shows Towers Watson s highest-rated hedge fund managers. It is clear that the reduction in risk by adding the next manager is indistinguishable well before reaching a 30-manager portfolio. There are other factors in addition to volatility reduction, such as the liquidity of the portfolio and achieving the right strategy allocation at a higher level, that have to be considered when justifying a higher manager count. But we would argue that a portfolio of more than 20 to 25 managers begins to look more like an index making it increasingly difficult in our minds to justify high fees. Finally, the added complexity of a large manager lineup makes it more difficult to stay Figure 1. Benefits of hedge fund manager diversification 16% 14% 12% 10% 8% 6% 4% Where additional managers have minimal impact in reducing volatility 2% 0% Number of managers on top of each manager in the portfolio and creates governance challenges that are unnecessary if the portfolio is constructed appropriately. Complementary Strategy, Style and Manager Allocations Diversification across strategies and styles, and low pairwise correlations between managers should ideally lead to a portfolio that exhibits low volatility and beta while still generating alpha. A hypothetical portfolio will help us illustrate how powerful this diversification effect can be in a hedge fund portfolio. Importantly, the primary goals of this portfolio include low annualized volatility and low beta to equity markets. Where the client already has a significant public equity allocation, the ability of the portfolio to serve as a diversifier is just as important as its ability to generate returns. Strategy Allocations As illustrated in Figure 2, the portfolio is allocated across several broad strategies. It was built with a higher allocation to diversifying strategies such as macro and statistical arbitrage, which tend to exhibit less volatility and beta than more directional strategies such as equity long/short. A sizable allocation to smart beta managers was included these funds are structured to capture many of the diversifying characteristics of hedge funds, but at a fraction of the cost. * Figure 2. Strategy allocation for the hypothetical portfolio Proposed hedge fund strategy breakdown 11% 9% 9% 11% 18% 17% 11% 15% 17% Credit long/short 15% Equity long/ short directional 11% Multi-strategy 18% Discretionary macro 9% Systematic macro 9% Smart beta CTA 11% Smart beta Reinsurance 11% Equity long/shortstatistical arbitrage There is a balance between achieving diversity in a hedge fund portfolio and having too many managers in the portfolio so that it dilutes any meaningful benefit from strong manager selection reflected in returns. * For more details on Towers Watson s smart beta thoughts and capabilities, please contact your Towers Watson representative for a copy of Understanding Smart Beta, August Hedge Fund Portfolio Construction: Key Considerations 2

3 Manager Allocations and Relationships While diverse strategy allocations are important, it is just as important to make sure that the underlying managers are generally uncorrelated in order to achieve the type of portfolio volatility profile (i.e., low volatility with downside protection) that most institutional clients demand. One way is by allocating to managers that have different styles, even if they trade the same broad strategy classification. To illustrate, consider a few examples in Figure 3 and the references within. Managers one and two are each credit long/short managers. However, despite trading in the same markets (i.e., credit spreads and related securities), the correlation between the two is fairly low, at only This is because they each have very different styles. Manager one is a bottom-up, fundamental manager that does deep analysis and research on individual companies, and also does a fair amount of investing in Asia. The other manager is tradingfocused, tends to run a fund that is market-neutral to spreads and rates, and is focused on short-term technical factors and trading spreads between developed-market debt securities. Managers three and four are traditional equity long/ short managers that take a fundamental approach to stock selection, taking long positions in companies they think will appreciate and short positions in companies they believe are overvalued. While these two managers exhibit a low correlation with each other (in this case, 0.10), a third equity-focused manager exhibits the same characteristics as well as broader benefits. Manager 11 trades equities based on a statistical approach that focuses on the relationship between securities over time and the propensity of the relationships to mean revert, and has a low correlation with each of the other equity long/short managers in the portfolio (0.0 and 0.1). Further, the manager maintains a book that is neutral to equity market beta and also exhibits a return profile that can be complementary (i.e., uncorrelated) with other strategies for instance, the manager s correlation with the overall portfolio is among the lowest, at Macro-managers can deliver returns that are uncorrelated with major markets and often post positive returns during challenging market environments as other strategies suffer (e.g., many were positive in 2008). This diversifying element and the potential to offer downside protection were therefore important considerations in constructing the portfolio. In addition, the macro-allocation deliberately included three managers that had historically low pairwise correlations due to their style differences. Manager seven is discretionary and focuses almost entirely on trading Asian interest rate, foreign exchange and equity markets. Manager eight is also discretionary and focuses entirely on G7 interest rate trading. Finally, manager nine is systematic (i.e., rulebased and model-driven) and trades across a variety of markets and asset classes. While a core competency of each manager is to formulate macroeconomic views across countries and markets, and then express these views through investments, managers are still quite diversified by region, asset class and style. While diverse strategy allocations are important, it is just as important to make sure that the underlying managers are generally uncorrelated in order to achieve the type of portfolio volatility profile (i.e., low volatility with downside protection) that most institutional clients demand. Figure 3. Examples of allocation by manager style Correlation Pairwise correlations to total portfolio # Credit L/S manager (7%) Credit L/S manager (9%) Equity L/S manager (6%) 0.4 A Equity L/S manager (9%) Smart beta Reinsurance (11%) Multi-strategy manager (11%) Discretionary macro-manager (7%) Discretionary macro-manager (11%) 0.2 C Systematic macro-manager (9%) Smart beta CTA (9%) Equity L/S manager statistical arb. (11%) 0.1 B B Hedge Fund Portfolio Construction: Key Considerations 3

4 Factor-Based Projections and Stress Testing While back-tested returns are certainly useful for understanding the historical characteristics of a given manager s portfolio, they are still historic data. This understanding of history, supplemented by transparency and applied to current asset classes, regions, sectors and, in many cases, individual securities that are held by managers, allows for forward-looking analysis and scenario testing. Rather than simply relying on the historical returns of the underlying managers, in this important stage of the process, we map the exposures of each of the underlying managers (e.g., equity, credit, rate, currency, commodity) and attempt to project how the portfolio would have behaved in previous environments given each manager s current positioning, as illustrated in Figure 4. * This allows an investor to formulate expectations of the future sensitivity of the portfolio to similar stress- scenarios, as well as material up and down movements in asset classes. Volatility and Correlation Stress Testing Additionally, a considerable amount of quantitative and qualitative effort is employed to project what each manager s potential downside is based on their volatility profile and, critically, to stress perceived correlation benefits of each manager that were considered and discussed earlier. This part of the process helps us understand whether there is too much reliance on our perception of worst-case scenarios or the correlation benefits of each manager, especially since during extreme stress environments, volatility levels can significantly exceed normal levels, and correlations can dramatically increase as risk assets sell off in tandem. For example, we consider the historical volatility of each manager and the loss implied by a two-standarddeviation move. Then, our dedicated hedge fund research professionals, in conjunction with our portfolio construction specialists, will assign a left-tail multiplier to this volatility projection. The multiplier can range from between one and five, and reflects our belief about how vulnerable a manager is to market shocks, particularly those that impact asset classes where the manager is exposed. Position-concentration levels, leverage and the liquidity of the markets in which the manager trades are all examples of things we consider when arriving at a multiplier. Figure 5, page 5, illustrates how these figures are used to calculate the portfolio s returns in stress environments. As illustrated, in our opinion, the worst-case scenario is the very unlikely chance that all managers are perfectly correlated during a stress scenario and that each experiences its maximum projected loss the result, as one would expect, is considerably worse than the historical two-standarddeviation portfolio return. While back-tested returns are certainly useful for understanding the historical characteristics of a given manager s portfolio, they are still historic data. Figure 4. Projecting portfolio behavior in previous environments Asian financial crisis 1998 Russian financial crisis September 11 attacks TMT bubble bursting 2007 subprime markets Credit seize % shock to equity markets 10% shock to US$ exchange rate 100 bp shock to interest rates Bull market move Bear market move 30% shock to credit spread 10% shock to commodity prices Note: A bull market move is a favorable shift for a particular market; a bear market move is a negative. shift for a particular market. Non-dollar-denominated funds might still show a currency stress test in US$s. For illustrative purposes only returns are not meant to represent an actual client portfolio. * A third-party risk aggregator is utilized to assist in the calculations. Hedge Fund Portfolio Construction: Key Considerations 4

5 Figure 5. Hypothetical portfolio losses based on various loss estimates Estimated loss Historical Projected Historical Left-tail adjusted Projected Left-tail adjusted Using historic manager correlations 5.0% 6.3% 15.4% 19.5% Assuming manager correlations = % 11.7% 32.7% 36.2% Assuming manager correlations = % 15.8% 42.7% 48.5% For illustrative purposes only returns are not meant to represent an actual client portfolio. Figure 5 shows hypothetical expected portfolio losses using the following volatility-based loss estimates: Two-standard-deviation historical. Based on the realized volatility of past returns for each of the underlying managers Two-standard-deviation projected. Based on the estimated forward-looking volatility of returns for each of the underlying managers Two-standard-deviation historical, left-tail adjusted. Based on the realized volatility of returns for each of the underlying managers, with a left-tail multiplier applied to each manager s historical volatility Two-standard-deviation projected, left-tail adjusted. Based on the estimated forward-looking volatility of returns for each of the underlying managers, with a left-tail multiplier applied to each manager s historical volatility While this exercise has a number of uses, perhaps its most important use is to determine the differences in stress-environment returns and their sensitivities to things such as correlation. This also applies on a time-series basis, where changes in these metrics over time can signal an overreliance on assumed correlation benefits or volatility assumptions. Back-Tested Returns In combining the universe of appropriate managers with the guidelines, principles, risk analysis and judgment noted in this article, the portfolio manager will determine an initial portfolio that is expected to meet a client s objectives. A review of how this aggregate portfolio would have behaved historically is then a valuable analysis, all while overlaying the analysis with qualitative judgment to account for things that are not easily measured (manager conviction, among other factors) before the final portfolio is determined. In Figure 6, we consider the return profile of the hypothetical portfolio that was discussed above and develop back-tested returns for a period spanning several years. Generally, the goals as specified at the outset of this exercise were achieved over this period: The portfolio would have exhibited lower volatility than equity or credit markets, as well as the benchmark HFRI Hedge-Fund-of-Funds Index (HFRI FOF), despite having allocations to only 11 underlying managers versus hundreds (on a lookthrough basis) in the benchmark. Further, the portfolio s beta to equity and credit markets would have been quite low. Finally, during periods of market declines and stress, the portfolio would have managed to preserve capital with minimal drawdowns. In combining the universe of appropriate managers with the guidelines, principles, risk analysis and judgment noted in this article, the portfolio manager will determine an initial portfolio that is expected to meet a client s objectives. Figure 6. The return profile of our hypothetical portfolio The result is a portfolio with low beta, volatility and downside protection. It is designed to be a complement to existing asset allocation. Volatility versus benchmark (HFRI FOF) is lower despite 11-manager portfolio versus hundreds. Returns (%) Return pa (%) Best and worst Month QTD 1 yr 3 yr SI* month SI Volatility (%) SI Sharpe Ratio SI Beta SI Max (%) drawdown Portfolio Objective Benchmark ** Equities ** High Yield Notes: Equity is MSCI AC Global; High Yield is Merrill Lynch US High Yield Master II. * SI means since inception of the portfolio (April 1, 2008). ** Indicates the recovery is ongoing For illustrative purposes only returns are not meant to represent an actual client portfolio. Recovery (months) Hedge Fund Portfolio Construction: Key Considerations 5

6 Controls and Ongoing Monitoring Critical to the process is the control environment, which we believe is enhanced by including experienced professionals in the approval process who are not exclusively focused on hedge funds to bring additional high-level objectivity. These professionals serve as independent and objective client advocates. The goal at this stage of the process is to incorporate a healthy dose of skepticism about underlying managers in the portfolio and their allocations so that a relationship with a manager, or bias toward a manager or strategy, doesn t cloud judgment. Finally, once a portfolio is implemented, there should be a formal, ongoing process for review in which many of the same considerations discussed above are again vetted. This ongoing review process is critical since a less-than-robust process and ongoing resource commitment can lead to materially negative outcomes, given the flexibility that hedge funds may have to deviate from previously understood parameters. Both Art and Science The process of constructing a hedge fund portfolio is both an art and a science, and can be very iterative in nature before the final portfolio is ually implemented. We hope this brief paper illustrates many of the tasks inherent in building an appropriate hedge fund portfolio for a client s unique situation. Further Information For further information, please contact your Towers Watson consultant or: Leon Beukes, FIA leon.beukes@ Mark Davis, CFA mark.davis@ Damien Loveday, CFA damien.loveday@ Douglas Smith, CFA douglas.smith@ Please note: This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions, and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document, Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watson s prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates, and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document, including any opinions expressed herein. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of benefits, talent management, rewards, and risk and capital management. Copyright 2013 Towers Watson. All rights reserved. TW-NA