Michael O'Dea

The US equity market has climbed almost 100 per cent from its lows of March, 2009. But over the past 10 years, the market has returned only 3 per cent a year – with considerable volatility.

Global aggregate debt levels remain at peak levels and without a resolution of this debt overhang, systemic risk remains a concern.

The US and other developed economies are dependent upon the current low level of interest rates in order to finance interest repayments at the same time as funding the ongoing costs of social welfare programs. Persistently high unemployment rates and rapidly ageing societies do not help matters.

The weakening political resolve for supportive government policies creates uncertainty and a less than favourable environment for bond and equity markets – the stalwart exposures in many investors’ portfolios.

In addition, most investors use market capitalisation weighted benchmarks – where a company’s weight in the index reflects the number of shares on issue multiplied by its market price – as their starting point. These indices are biased to big stocks, which are not always the best performing stocks.

A better starting point may be to relax certain portfolio constraints and to invest in the widest possible universe of securities, focusing more on company fundamentals rather than market cap weighting. This is the essence of an active management approach to investing and it is basic premise for many hedge fund strategies.

Hedge funds offer three areas of potential diversification to investment portfolios:

1.      Security diversification: Hedge funds invest in securities which are not typically held by institutional investors such as convertible bonds, distressed securities, asset backed loans et cetera. These securities may have different economic drivers of returns than equities.

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2.      Strategy diversification: Hedge fund strategies which use macro-economic analysis to determine positions include GTAA and Global Macro. The performance of these managers has historically had very low correlations to equity and bond markets.

3.      Skill: There are many ways in which investors can capture momentary mispricings in the market across a range of different markets and securities. More inefficiencies exist in areas outside of the glare of institutional investors and managers, who are less constrained and spend all their time in one small area of the market, are likely to have an edge over the average investor.

However, hedge fund investing is not without its risks. The problems of hedge funds’ limited transparency, high fees, and failing to meet investor redemptions during the GFC should not be ignored, but one way to overcome these issues is for an investor to gain access to hedge fund strategies via a well structured multi-manager program.

The use of managed accounts can be a powerful tool to overcome a number of issues. This is where the assets/securities are held in the investor’s (or a third party’s) name, rather than the manager holding these assets in their own vehicle. This helps limit the risk of fraud, provides the investor with total transparency and affords much greater control over the investments.

In every market environment there will be some winners and some losers in the hedge fund space so diversification across strategies and managers will help stabilise returns. By following a carefully developed plan, an allocation to hedge funds can play a very meaningful role in overall portfolio construction. We believe that this can be achieved through careful selection of a multi-manager fund or for larger investors by accessing specialist advice for a tailored program.

Michael O’Dea is portfolio manager Triplepoint at JANA Investment Advisers.