Clustering of hedge fund returns - where is the difference?

A close look at all of the HFR hedge fund index returns over the last three years shows a significant amount of clustering of styles with the only outliers associated with country and sector indices. For 60 indices, the average three year (May 2014 - May 2017) annualized return was 3.04 percent and the average annualized volatility was 5.61 percent. Outliers are focused on sector indices like technology and energy and country or regional indices like India or Latin America. 

The quest in hedge fund investing is to find managers who do not fall within the cluster but can generate better returns. Of course, the range of return and risk would be wider of individual managers but if you had to start with a simple judgment of what you will receive with a portfolio of hedge fund managers it is likely to be closer to an information ratio of .6 and a return and risk of 3 and 5.5 percent. These numbers are dynamic, but they are a long way from the expectations that managers provide information ratios above one and annualized returns over 10 percent. 

Smart beta - Why look at these investments? Diversification

The FTSE Russell annual survey on smart beta does a good job at describing trends in investor thinking with respect to this growing area of portfolio allocation. Smart beta is extending its breath and reach to other asset classes as well as a wider selection of risk premiums and formats. What is still clear is that investors are looking for smart beta in all forms to help with risk reduction and improve diversification. These are the number one and three reasons for holding exposures. Nevertheless, the fastest growing investment objective is cost savings. It is likely that smart beta is being used as a substitute for more expensive active management. 

The number one smart beta strategy is a multi-factor combination with low volatility and value coming in second and third. There is a clear investor bias for having factors blended under the name of smart beta. 

This desire for multi-factor combinations gets to the heart of one of the key issues of smart beta. At what point is smart beta allocated across a number of factors quantitative active management allocated across a set of strategies through a set of rules? The lines are blurring and this will have an impact on the costs and demand for active managers. The active manager will have to prove whether he is smarter than a smart beta portfolio.

Can momentum and diversifications solve every investment problem? Perhaps.

I listened to a number of presentations concerning crisis alpha and crisis offset at a recent hedge fund conference. The idea of holding assets and strategies that will do well in "bad times" is a critical issue for any portfolio construction discussion. It is the bedrock and foundation of any portfolio that attempts to protect against bad states of nature, control risk, and gain during good times.

There are two solutions that will mitigate negative return extremes in any crisis:

1. Diversification - Loses will always be less even if correlations increase during a crisis if there is a well diversified portfolio in place. Nevertheless, diversification is not a "one size fits all" solution. The level and choice of diversification is an active decision no different than the choices made to increase return. Diversification is an active bet on correlation and volatility. 

While not oversimplifying, different asset classes and strategies have different responses to "bad times" or crises. Hence, the cross-asset returns and correlations will change with the business cycle and with changes in the financial environment. If there is the expectation that crises are more likely, investors should be increased demand for assets that have characteristics of negative or low correlation during these states. 

2. Momentum  - Increase allocation to winners and cut exposures to losers. This is the simplest form of momentum. The next level of momentum trading is to short losers. Everything else could be considered just extra to portfolio construction. Of course, there are numerous ways of measuring winners and losers and there can be wrinkles based on forward expectations, but the concept is still very straight-forward. Momentum may not predict a crisis, but if a crisis occurs, momentum will help any investor to get on the right side of the market move. The adjustment from momentum occurs without even a clear view on the how or why a market declined. It is non-predictive and simply responsive to market forces.  In a macro sense, momentum adds the equivalent of option gamma to the portfolio.

If you want to add an extra, do one thing:

Risk manage the portfolio - Allocate based on volatility (higher volatility tied to lower risk exposure). Target volatility so that if correlations move to one there is a cut in overall risk exposure. If the momentum signals will not adjust fast enough to market directional changes, then use stops to exit the market. 

Asset management may not be that simple in reality, but it can be that simple in terms of guiding principles. If in doubt of what should be done in any situation, the guiding principles of diversification and momentum can serve as a first pass for construction. 

Two components of active management, style and skill - Investors need to choose both wisely

There has been much discussion about benchmarks and beta with hedge funds, but it is important to take a step-back and discuss how active returns are generated. Active management can be divided into two parts, the style used and the skill employed within that style. You can call a style a risk premium as is the case for value or small investing; however, all returns from styles may not be from risk premiums. Style is simply a descriptor or means for generating returns. Skill comes with the method of employing the style. Within a style, some managers are better at it than others. 

Styles will differ because they attempt to capture different return streams. A value investor will be different than a global macro manager because they are attempting to find different return phenomena. A momentum manager will clearly be different from merger arbitrage. If the style is not associated with a clear risk premium, then it may have to be measured by a peer group. In this case, skill is ability to beat the average of a set of peers. 

Styles may go in and out of fashion no different than risk premiums may be time varying and change with a market or business cycle. Hence, there can be a skilled manager within a style, but if the style is generating poor returns, the manager's skill may not be able to offset the negative style effect. Finding the best may not be good enough. Style choice and diversification matters. Some will say choose your manager wisely. Perhaps more important is choosing your the styles for your portfolio wisely.