The Responsible Search For Portfolio Diversification

Apr 17 2012 | 1:41pm ET

By Andrew Lapkin, HedgeMark International -- Investors have been searching for diversification since the earliest days of investment management. The evolution of institutional investors’ asset allocations can be viewed as having gone through a basic progression, as follows:

1) Equity vs. Fixed Income
2) Allocations amongst different equity styles (Growth / Value – Large Cap / Small Cap)
3) Allocations within Fixed Income  (Corp, Gov  / Short, Medium Long / High Grade , High Yield)
4) Allocations to global assets both Fixed Income and Equity across dozens of countries
5) Private Equity
6) Real Estate
7) Hedge Funds

Hedge funds?  Why did hedge funds get their own category? While it is easier to argue that each of the other line items represents an asset class or a sub-set of an asset class, the idea of a typical hedge fund allocation does not make much sense. When viewed as an asset class, hedge funds represent investments that have low correlations to other asset classes. However, the hedge fund universe has become so large, and the range of styles, exposures and volatilities so broad, that it is silly to place all hedge funds under a single umbrella.   

It is no surprise that investors have been increasing their allocations to hedge funds. Correlations among managers in all asset classes have been increasing, especially during periods of market stress. As a result, investors seeking better portfolio diversification are craving absolute return managers or those managers that can deliver lower volatility and lower correlated returns. Many hedge funds fit the bill; the danger is grouping all hedge funds under a common allocation. Rather, it makes more sense for hedge funds to be viewed as active managers and slotted into one of an investor’s core asset classes. A good question is why is this rarely done?

There are a range of possible explanations, but if you look at the evolution of hedge funds, much of this can be attributed to the broad mandates of many of the earliest hedge funds as well as the limited transparency afforded to most hedge fund investors. While force of habit may lead institutions to still consider hedge funds as an asset class, the range of available managers and access to transparency should be leading all investors to view hedge fund investing as just another path to selecting the most talented managers--those capable of adding the most alpha. 

There are a number of facets that distinguish many institutional investors approach to hiring asset managers: 

 - Written investment guidelines
 - Benchmarking of returns to a major index
 - Detailed performance attribution
 - Position transparency for fund level and aggregate reporting
 - Proper control and governance over the assets

It is surprising that allocators to hedge funds typically ignore all of these tenets. Investors have been quick to deviate from their traditional approach to selecting and monitoring managers under the assumption that all hedge funds would have low volatility and low correlated returns. That approach may have been acceptable when investors were testing allocations to hedge funds by allocating a couple of percent in total across a number of funds. This approach breaks down as the size of the allocation increases. Investors suddenly lose the ability to understand their total portfolio’s exposure, risk and benchmark tracking profile. Furthermore, a more substantial portion of many investors’ portfolios are now held without the proper governance, controls and protections that is common to most other forms of investment allocations.  Investors have been willing to ignore these deficiencies as a result of the quality of the returns from many hedge funds, especially during market drops. This has led to the desire to greatly increase allocations. The question is how to allocate 15%, 20%, 30% or more to funds that are vastly different yet grouped under the same banner. The solution is to treat hedge funds as an extension of the traditional asset classes. Equity hedge funds should be viewed as active equity managers. Fixed income and credit relative value managers should be viewed as active fixed income managers, etc.

Classifying Managers

The key to this approach is having access to the right data and information to analyze the funds, both pre- and post-investment. This requires access to a level of data that traditionally has not been available to investors. Fortunately, that is changing. Investors now have access to hundreds of hedge funds via direct managed accounts or through a managed account platform. In a direct managed account structure, the investor hires the hedge fund manager to trade a separate account controlled by the investor. However, a managed account only provides the investor with the information to allow for proper monitoring and governance and the investor still needs to have the right tools and internal capabilities to properly monitor the account. In a managed account platform, the platform operator maintains a separate account and pools investors together, while also performing designated oversight functions. The key is that in both cases, investors are able to invest with managers in a manner that follows industry best practices. This includes having written investment guidelines along with access to daily position information required for performance attribution, detailed exposure and risk reporting and the ability to actively monitor that information. Importantly, access to position level detail also affords the investor the opportunity to include their hedge funds in with their existing portfolios to calculate a benchmark analysis at the asset class level and total portfolio level. Thus, an investor is able to include all of their managers (index, long only, and hedge fund) into a single analysis to ensure that investors and their boards can properly track and understand their total portfolio’s positioning relative to a selected benchmark or policy portfolio. The hedge fund is nothing more than a highly active investment manager, but now treated in the same way as all other investments. 

To meet future investment return goals means creating portfolios that are risk managed and well diversified. Unfortunately for investors, the ability to create a well-diversified portfolio by solely allocating across traditional asset classes appears to be over. Long only investing has proven too volatile and most investment managers too highly correlated in periods of market stress. As a result, active management must expand beyond minor deviations from an established benchmark. Including hedge funds as active managers within a specific traditional asset class mandate instead of as a separate category makes sense. What has been lacking is access to the data and fund structure necessary to follow this route. Managed accounts and managed account platforms provide the solution. Under these structures, investors no longer need to ignore their key investment principals under the auspice of gaining access to low correlated, absolute return managers. Instead, investors gain access to the information needed to properly choose and monitor highly active investment managers. A managed account allows investors to ensure that managers trade within reasonable investment bands, and ensures access to the data required to conduct the performance, exposure and risk calculations necessary to assess the role of the fund within the broader portfolio. A return to the days of creating well diversified portfolios in a responsible way.

Andrew Lapkin is the president of HedgeMark International LLC, an independent hedge fund managed account and managed funds platform with an integrated high-frequency hedge fund data aggregation and risk transparency system.

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