Think you can pick hedge funds? Think again.

Active hedge fund selection is challenging - a passive approach to hedge fund investing is appropriate for most investors.

Amid the roll-out of travel restrictions and lockdowns, when equities were falling and volatility was soaring, were you worried about the relative performance of your equity portfolio? It seems unlikely. With equities collapsing, there was little question yours would be down along with everyone else’s. Bonds? They seemed to be holding up well.

More likely, it was your hedge fund portfolio that caused the greatest amount of anxiety. “How much risk did my long/short fund have on?” “Was my CTA long or short equities?” “Can my credit fund cope with liquidity?” “Will any of my funds blow up in this chaos?”

Valid concerns - many popular funds suffered large losses, whether because of equity managers overly focused on a particular sector, macro funds caught on the wrong side of trades or managers who had been too aggressive with liquidity and pricing. There were a few performance blow-ups too.

But it’s strange we should agonise so much over our hedge fund portfolio, which makes up such a small part of total portfolio risk. The diversifying nature of hedge funds and their low volatility compared with equities mean their returns are likely to be more stable, and have a risk-reducing effect on the portfolio.

Of far greater concern are our active decisions over hedge fund selection - and such concerns are justified because the reality is that picking hedge funds is extremely difficult.

Chart 1 shows just how difficult. It compares the last 20 years of monthly returns for the HFRI Fund Weighted Index (a passive index) with those of the HFRI Fund-of-Funds Index (the active index, comprising actively selected ‘best’ hedge funds).

Now, we’re assessing just the skill of these active fund-of-fund managers, so we shall add back a generous 1.5% per annum to their return, which should more than cover their fees for active management.

Chart 1:

Active hedge fund selection has underperformed passive

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For illustration only.

Past performance is not a guide to future performance. The value of your investment can go down as well as up. You may get back less than you invested.

As you can see, even after adding back 1.5% p.a. to the monthly return, active hedge fund selection has performed worse than the passive hedge fund index.

We’re certainly not saying it’s impossible to add value through active hedge fund selection. On the contrary, our colleagues in hedge fund research have done an excellent job of finding top-tier hedge funds. But to do this well requires significant resources that few can justify (at ASI, we have 50 hedge fund professionals focused on this task). And even the best-resourced active managers can’t guarantee success (as shown by March 2020 returns of Skybridge or Blackstone’s regulated multi-manager funds, for example).

The truth is, even if we dedicate the time, money and people to selecting hedge funds, it’s difficult. First, hedge fund strategy performance goes in cycles. These cycles vary in length and are sensitive to external shocks (such as Covid-19). Second, and probably more importantly, hedge fund performance varies hugely from fund to fund.

Year-to-date, fewer than 50% of the constituents of the HFRI 500 Index (the Hedge Fund Research Index of ‘investable’ hedge funds) have actually beaten the index. With such a low hit rate, active fund selectors are already facing an uphill battle from the word go.

The magnitude of their challenge is illustrated in Chart 2, which compares the distribution of returns for 2019 and Q1 2020 for liquid alternative benchmark constituents. Selecting even one of the poorly performing funds in the left tail of this distribution for our active portfolio would have been painful.

Chart 2:

Distribution of HFRI-I Liquid Alternative UCITS Index contituent returns, 2019 and Q1 2020

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Fortunately, there is another way to allocate to hedge funds. Equity investors are familiar with passive investments. Indeed, in the US, half of equity investments are now made through passive vehicles. Attempts have been made to replace direct hedge fund investments with simpler approaches (such as alternative risk premia and hedge fund replication), but none has delivered what we see in the equity world.

Instead, investors should take a more simple approach to hedge fund investing, being truly passive by investing in each benchmark constituent. This may sound daunting for most investors but, fortunately, investment products do exist that do the work for us.

By physically replicating a hedge fund benchmark, we can seek to reduce the risk attached to any particular fund or strategy.

By physically replicating a hedge fund benchmark, we can seek to reduce the risk attached to any particular fund or strategy, albeit capital will always be at risk. Instead, we are essentially making a diversified allocation to the hedge fund industry (comprising actively managed funds), in a clean and simple product. This frees up time and resources to focus on the bigger parts of the portfolio that will really move the needle.

HMF InvestHedge, 25/5/20

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The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.

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