Hedge Funds

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Hedge Funds
An attractive alternative for the multi-cycle investor
I
n 2008, global equ it y mark ets declined sharply and credit spreads
blew out to historic wides. Investors found that there were few places to hide as
correlations across asset classes trended toward “1.” It is not surprising that
investors have reacted by reducing allocations to equities and increasing allocations to fixed income assets. But what was most different in this downturn
involved how liquidity risk played out, driven by an unprecedented amount of de-leveraging throughout the financial system. For many, this brought into question the merits
of the much heralded “endowment model,” which seeks greater exposure to hedge
funds and other alternative strategies. With 20/20 hindsight, was it a mistake to hold
large allocations in alternative investments? Coming into year-end 2008, it certainly felt
that way as investors experienced redemption queues in core real estate funds and
hedge fund managers imposed gates and limited the amount available for redemption.
These liquidity events occurred even as some diversified investors also became saddled
with large unfunded private equity commitments.
Sizing Up Allocations
Yet as we look ahead in 2010, many investors have kept their strategic allocations to
alternatives very much intact. How does the negative experience for most investors
Hedge Funds: An attractive alternative for the multi-cycle investor
in alternatives nearly a year ago square with the positive
stance that many of these same investors are taking today?
The conclusion reached by many is that the lesson learned
was less about the merits of the strategies they invested in
and more about the size of their allocations in less liquid strategies. This increased awareness of liquidity risk is particularly
true for investors in private equity as it affects their ability to
fund capital commitments. The key questions today are: is a
less liquid investment sized properly in the totality of a portfolio considering an investor’s liquidity needs? And, secondly,
will the investment provide a rich enough premium over public
markets to justify the increased liquidity risk? Investors who
feel that they over-allocated and over-paid may lick their
wounds, but they won’t abandon these strategies entirely
because an undiversified and unhedged liquid beta-centric
equity and/or credit investment has its own risks.
Alpha vs. Beta
Another theme driving investors is how to achieve a better
mix of alpha and beta. After the tremendous rebound in
equity and credit market indices throughout 2009, beta may
not deliver returns as handsomely in 2010 based on a historical regression to the mean. Therefore, we believe that
active managers who invest with more of an absolute return
objective and who are more agnostic about benchmarks may
be an option worth considering. In other words, if an investor wants exposure to emerging markets, he or she may
seek to hire managers with track records indicating that they
can provide better differentiation than an indexed strategy
by, for example, identifying truly emerging markets and
avoiding potentially “submerging” markets globally. Or, in
the case of a fixed income strategy, an investor may choose
to invest with managers who have demonstrated a high “hit
ratio” for avoiding negative credit events. If one extrapolates
on this theme of more alpha and less beta, an allocation to
hedge funds is a natural extension because they represent
the purest form of unconstrained active money management
and maximum risk-adjusted returns (using tools such as
shorting and leverage.) In our view, hedge funds are not—in
and of themselves—an asset class. They are simply a way
to access a subset of skill-based money managers in equity
and credit strategies.
The ‘Endowment Model’
Looking at hedge funds in this way leads to a better understanding of the reasoning behind the decision of many of the
larger endowments to shift from “beta one” strategies1 to
hedge funds, a process dating back some 15–20 years.
Conceptually, the idea revolves around the notion that if an
investor could identify, access, and appropriately combine a
set of skilled active managers, then the expected outcome
would be a higher compounded return over time through a
more asymmetric return pattern than that provided by a
purely beta-focused portfolio. In other words, top-ranked
active fund managers in the alternatives space offer the
potential for better capital protection in adverse markets
and keeping pace with—or outperforming—their benchmark
indices when market returns are generally positive. The
objective lesson derived from the endowment model over
the past two decades is that it is important to look at longterm results. In practice, this means that the focus should be
on the track record through multiple market cycles instead
of one-year performance snapshots, which may be misleading. And endowments have had the patience and persistence
to identify hedge funds with multi-cyclic outperformance and
to cultivate long-term, mutually rewarding relationships with
top-ranked managers.
A Healing Process
Many hedge fund managers “gated” their investors by placing limits on redemptions in 2008 and early 2009, which was
a big area of disappointment for those invested in these
strategies. The other factor that disillusioned investors was
the generally poor returns from most hedge funds during a
time of great dislocations and volatility in the markets. But
did investors have realistic expectations in the first place?
The average hedge fund manager was down about 21% in
2008, according to the HFR diversified FoF index. But as
poor as that may seem, that did not “underperform” the
major benchmark stock indices, which all were down over
40%. Some investors—usually those newer to hedge funds—
expected their managers to defy the law of gravity. But
hedge funds in aggregate cannot outperform on a sustained
basis when every major market gets crushed. Ultimately, all
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2 | Hedge Funds: An attractive alternative for the multi-cycle investor
“ Beta one” strategies are those with 100% exposure to market volatility,
such as long-only and 130/30 funds, as opposed to market neutral long-short
hedge funds.
fund managers swim in the same pool. The real problem may
have been in terms of these excessive expectations—and,
perhaps, marketing. Should hedge funds ever have been
introduced to people as a kind of turbo-charged “cash plus”
alternative? Probably not. We believe it wisest to approach
hedge funds as a semi-liquid asymmetric play that performs
best over multiple cycles. Even so, as credit markets recovered and equity markets came off their lows, many gated
hedge fund investors got their money back much quicker
than anyone had predicted. The “healing process” has been
twofold: First, it was important for investors who wanted to
get out to be able to do so. That cleared the decks, so to
speak. Second, hedge funds are no longer seen as “safe”
substitutes for long-only strategies—something they have
never been and should not have been viewed as being during
their bullish heyday in the mid-2000s.
Through the Looking Glass
Another outcome is that investors are demanding—and getting—better access to hedge fund managers and greater
transparency into overall operations. That usually involves a
deeper understanding of what’s going on in the portfolio,
including things like risk exposures. The new rule is: no surprises. Hedge funds have to regain the trust of their investors, who are no longer lining up and begging managers to
take their money. That may mean, for example, conference
calls on a more frequent basis and acceptance of much
stricter due diligence procedures. Simply stated, there is now
a more level playing field between investors and managers.
The regulatory environment also is likely to get tougher on
hedge funds in terms of registration and reporting requirements. And lock-up terms could become looser in response
to investors seeking improved liquidity. The days of a threeyear lock with a one-year rolling lock-up thereafter are long
gone. But we believe they won’t disappear entirely. That’s
because they originated as a way to protect investors in a
pooled vehicle from collectively suffering due to an arbitrary
redemption before an investment has matured. Therefore, a
reasonable lock-up period is to be expected in funds—particularly credit strategies—in which investments may take up to
three or four years to exploit fully. Fees are another area
that may not come completely unhinged—at least not for
top-quintile hedge funds—because investors pay for performance. That’s the dream of active money management—the
smartest guys in the room can pull a rabbit out of the hat.
In fact, only very few can pull it off, but, in our view, these
exceptions will be able to continue to charge a premium
for their skill sets.
Maximizing Opportunity Sets
While liquidity is a risk factor that investors cannot ignore,
cooler heads have prevailed and investors are focusing on
getting the right mix of liquid, less liquid, and illiquid strategies instead of abandoning hedge funds and other alternative investments altogether. Indeed, as long as the Fed
remains committed to keeping rates at historically low levels,
we believe that investors should not be “short” on beta, but
rather that they should look for a better mix of alpha and
beta. And to the extent that investors choose actively managed strategies, our view is that unconstrained active managers are best positioned to take advantage of superior riskadjusted return opportunities and to manage the downside
risk of left-tail events. More specifically, assuming an investor has not given up on active management, hedge funds
should continue to play an essential role in a well- diversified
portfolio. These limited partnership structures offer greater
flexibility to vary net market risk, hedging levels and leverage which, we believe, will result in a more asymmetric
return pattern than what can be realized by building a portfolio entirely with “beta-one” strategies.
J.P. Morgan Asset Management | 3
Hedge Funds: An attractive alternative for the multi-cycle investor
author
Jeff Geller
Managing Director
CIO, Global Multi-Asset Group, Americas
jeffrey.a.geller@jpmorgan.com
This document is intended solely to report on various investment views held by senior leaders at J.P. Morgan Asset Management. The views described herein do
not necessarily represent the views held by J.P. Morgan Asset Management or its affiliates. Assumptions or claims made in some cases were based on proprietary
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