Why Not Diversify Across Strategies Instead Of Asset Classes?

Mar 22 2013 | 7:40am ET

By Jan Viebig
CEO of Harcourt Investment Consulting

In recent times, diversifying a portfolio by means of hedge fund strategies has gained a lot of momentum amongst institutional investors, and we believe this tactic it is a good alternative to the more common practice of diversifying by asset classes.

"The risk and return characteristics of hedge funds are primarily dependent on the strategy they apply and less about the asset class they invest in," wrote William Fung And David Hsieh in their seminal whitepaper in 1997. Since its publication, a number of researchers have shown that hedge funds use a wide variety of dynamic strategies possessing strategy specific risk and return characteristics.

Today, specifically institutional investors do not simply diversify their entrusted assets across different sectors and continents, but also across various hedge fund strategies. Hedge funds however, are not homogenous and it should be noted that the risk and return characteristics as well as the diversification benefits are strategy dependent.

To justify this, the returns of the merger arbitrage strategies were examined and were shown to be uncorrelated to equity markets when they are trending upwards or sideways. However, to the detriment of investors investing in the strategy, the financial crisis confirmed that in times of declining equity markets many announced takeovers end up being postponed or cancelled. A further example is the trend following strategy, often called CTAs, which unlike merger arbitrage posted gains throughout the financial crisis. Through the use of CTAs investors were able to achieve diversification benefits at the exact point in time when it was needed the most (throughout the crisis as the markets collapsed and the correlation to traditional asset classes rose). These two examples underline that when investing in hedge funds, strategy selection is crucial.

We believe that, when selecting the right hedge fund strategy, the differing strategy specific diversification benefits need to be taken into account. Professional advisory services are a necessity as the hedge fund industry along with the strategies they use are homogenous.

Many investors criticise hedge funds for being too illiquid, too complex and too expensive, which is not completely unjustified: Hedge funds collect strategy specific returns and engage in strategy specific risks. A good strategy is one that possesses diversification benefits as well as uncorrelated risk adjusted returns that exhibit both liquidity and transparency.

In 1974, when most U.S. investors invested predominately in local markets, Bruno Solnik asked in a famous article: "Why not diversify internationally rather than domestically?" Today, investors can not only diversify across different sectors and countries but also across different strategies. We therefore ask: "Why not diversify across different strategies rather than investing only in long-only strategies?" If you invest in traditional equity or bond fund, over 90% of the risk depends on one single variable: the direction of the respective market. We believe that some of the best advice for investors today is to diversify across different sectors, different countries and different strategies. A pure buy and hold portfolio is not necessarily an efficient portfolio.

Jan Viebig is CEO of Harcourt Investment Consulting AG and Head of Alternative Investments. He is also member of the Management Committee and the Investment Committee of Vontobel Asset Management. Prior to joining Harcourt, he worked from 2010 to 2012 as Head of Emerging Markets Equities at Credit Suisse in Zurich, where he led and managed the investment team. Previously, Jan worked from 1999 to 2009 at DWS (Deutsche Bank Group). Initially he was Senior Portfolio Manager for international and emerging markets and later Managing Director and Hedge Fund Manager managing various long/short equity, absolute return and long-only funds.

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