What we possess as young children, which very often fades with age, is our ability to use our imagination. If we step back and incorporate a holistic view of the industry, we can see that it is not only the hedge funds that are changing. It is useful to imagine how we may best alter our modelling of the efficient frontier and the asset allocation policies that govern the prudent decisions we make for our clients.
The broken Fund of Funds model is ripe for a makeover. We think that the following changes will and should affect the portfolio optimization process that is undergone by fiduciaries such as RIA’s and advisors who allocate to hedge funds.
1. Fund selection. A more effective fund selection will most likely entail:
- Fewer funds, so that we avoid “diworsification”
- Hedge funds that actually hedge in an extended bear market
- Younger or smaller funds
This topic has been the subject of other articles on our blog, and will be discussed further in subsequent pieces that we will post.
2. Asset allocation. It may be useful for RIA’s, consultants, and advisors who allocate to hedge funds to consider our thoughts about how to reform the asset allocation process and shift the efficient frontier.
There are two facets of the asset allocation process that are worthy of reform: capital market assumptions that express the expected risk/return for hedge funds, and the correlations that capture the relationship between hedge funds and other asset classes in the rest of the client’s portfolio (long only assets).
We think that if these changes are considered, the total amount of any client’s portfolio that may be commonly suitable for hedge funds would drop from 15-20% to within a 5-10% range. Although each client is different, we have seen that many investors are being underserved by having too large a percentage of their portfolio placed into funds that are long the market risk premia.
Capital Market Assumptions
Many Investment Policy Statements are governed by capital market assumptions that are mean-reversion based, or perhaps based on a historical regression. We feel that perhaps a more heuristic basis will more realistically capture hedge fund risk/return profiles. With such different risk premia involved from strategy to strategy, it is better to assign a different risk/return to each type of hedge fund: global macro funds, for example, would act entirely differently than long/short funds.
We imagine that it would be more prudent to include a “transparency risk premium” to each hedge fund assumption. While some strategies are more opaque than others, complete visibility is never guaranteed with hedge funds.
- Indices are replete with bias
- Stale pricing prevails at the fund level
- There are no universal performance standards
- Leverage may often obfuscate true performance
For these reasons, modelling hedge fund behaviour is a black box to start with. It should be treated that way. Unknown factors can have great impact and risk premia should be adjusted upwards.
When the market crashed, many hedge funds exhibited higher correlations to long only asset classes than was expected. The correlations that should be used are those that prevail in turmoil, not over the entire track record. This is when hedge funds are called to action, and should be the lens that we look through when making an allocation decision.
Bottom Line for Asset Allocation
If we were to remodel the capital market assumptions with higher risk premia and correlations, it is likely that the efficient frontier would morph. We would probably see optimal portfolios that include smaller allocation to hedge funds, probably a 5-10% range.
Until hedge funds change their game, we think this paradigm would enable fiduciaries to make more informed and prudent decisions for their clients.