Diversification: the road less travelled

In today’s low-yield environment, re/insurers are fi nding it diffi cult to meet their return targets, particularly with investment portfolios typically dominated by investment-grade fi xed income securities. At the same time, re/insurers are seeking to diversify portfolio risk profi les away from undue concentration in credit risk, stemming from sizeable exposures to fixed income credit sectors and equity market beta.

As a result the industry is paying increasing attention to alternative investment strategies, such as hedge funds, as a potential path to higher returns and improved risk diversification. Here we examine a wide range of hedge fund styles and their potential fit within an overall hedge fund allocation.In particular, we highlight the important distinction between total-return and absolute-return funds and offer pointers for creating a well-diversified hedge fund allocation.

Diversifying a hedge fund allocation for better fit and efficiency

Not all hedge funds are alike

Investor interest in hedge funds stems in part from a desire to reduce exposure to volatile and sometimes highly correlated markets. While most hedge funds aim to achieve positive returns across market environments, their approaches, objectives, and results can vary significantly. For example, hedge funds whose main objective is stability of returns often have little systematic market exposure which, in lieu of leverage, may result in lower overall returns, particularly in strong up markets.

Funds that seek higher returns may employ more directional beta exposure and be more closely correlated with traditional markets. Such positioning is likely to produce greater upside capture in bull markets, but greater drawdown risk in bear markets.

Performance during the 2008–2009 crisis was instructive

The global financial crisis of 2008 vividly demonstrated the wide range of outcomes that different hedge fund styles can experience in extreme market environments (see Figure 1). When equities fell sharply during the crisis, funds with greater exposure to that asset class, including equity hedge and emerging market styles, were naturally among the hardest hit. As equities bounced back in the bull market of 2009, so did these styles.

Meanwhile, the hedge fund styles that had provided the most protection in the previous year, such as macro, equity market neutral, and merger arbitrage, lagged significantly.

Even more important than the variations in short-term performance among hedge fund styles are their widely differing long-term risk/ return characteristics. Historically, some styles have dampened the effects of market volatility, while others have boosted returns, in part through exposure to market beta.

Using historical returns from the Hedge Fund Research, Inc (HFRI) indexes along with those of a traditional balanced portfolio, Figure 2 displays the impact of gradual increases in exposure to different hedge fund styles on a portfolio initially comprising 60 percent equities, 30 percent fixed income, and 10 percent cash. Each line represents the risk/return trade-off of adding exposure to a particular fund style in 1 percent increments, from zero to 100 percent.

As one would expect, styles that seek positive returns with little or no systematic equity or credit market bias tend to reduce overall portfolio volatility while having a neutral to slightly positive effect on overall portfolio returns. Equity-market-neutral strategies, for example, have on average delivered significant diversification benefits relative to a traditional balanced portfolio as a result of their explicit focus on minimising exposure to various market risk factors.

At the other end of the spectrum are styles that incorporate significant directional bets or that tend to be net long beta over time, including emerging market, equity hedge, and event-driven strategies. Investors who select these styles expect more return enhancement, but with the additional volatility that comes with greater exposure to, and correlation with, market risks.

Total return versus absolute return

One of the key differentiating features of a hedge fund is the degree to which it focuses on total return versus absolute return. Where a strategy lies along this spectrum will significantly influence its behaviour across various market environments. Allocating to both return approaches can help diversify a portfolio of hedge funds by combining strategies likely to do well in bull markets with strategies designed to protect in down markets.

"Historically, some hedge fund styles have dampened the effects of market volatility, while others have boosted returns, in part through exposure to market beta."

Total-return hedge funds tend to have persistent long exposure to major market risk factors such as beta, leverage, volatility, and momentum, along with more aggressive return objectives and greater return volatility than absolute-return hedge funds. In contrast, the latter often explicitly neutralise systematic exposure to market risk factors and, absent the use of substantial leverage, experience relatively lower return volatility. Many absolute-return strategies focus on risk mitigation and return consistency rather than maximisation of return. In some environments, such as bear markets, an investor may prefer lower return targets with fewer and less severe drawdowns.

Total and absolute return: some practical applications

Adding long/short equity strategies to a traditional long-only equity allocation has several potential advantages in a total-return-oriented context; absolute-return approaches can help mitigate the trade-off between volatility reduction and asset growth for retirement plans and other liability-focused investors.

Number of managers: how much diversification is enough?

Our research suggests that a hedge fund portfolio can be diversified with a relatively small number of funds. The portfolio’s mix of styles, and how those styles are internally diversified and cross-correlated, are more relevant than numbers of managers in evaluating portfolio design.

Evaluating a fund-of-funds approach

Funds of hedge funds come in a range of formats, from externally and internally managed to multi-strategy approaches overseen by a single manager. We discuss the pros and cons of these various approaches from an investor’s perspective.

The full white paper can be found at: www.wellington.com/docs/diversifying_HF.pdf

Absolute-return strategies for the fixed income investor

While some insurers are exploring alternative strategies that operate partly or wholly outside the public fixed income markets, there are other paths to achieving positive returns across varied market environments that are centred more squarely in fixed income.

Wellington Management’s Global Total Return approach, for example, is an absolute-return strategy designed to be market-neutral and uncorrelated to traditional market beta and risk assets, with an alpha target of 4 to 6 percent over cash. This team-based approach aims to generate consistent absolute returns through allocations to multiple fixed income strategies, including fundamentally based macro, modelbased quantitative, bottom-up credit, and emerging markets.Each of these alpha sources is managed by a specialised portfolio manager or team of portfolio managers, and implemented across the broad global fixed income and currency markets.

By combining independent alpha sources, Global Total Return portfolios are diversified across investment styles (eg, fundamental versus quantitative), market sectors, investment themes, strategies, and time horizons, which ensures that portfolios are not dependent on any single source to drive returns. The diversification of active portfolio risk leads to more consistent risk-adjusted returns across a wide variety of market environments.

Adele Kohler is director of alternative investment solutions at Wellington Management.

Conor McCarthy is director of client investment solutions at Wellington Management.

For more information on Wellington Management’s alternative investment approaches and total-/absolute-return strategies, please contact:

US and Bermuda

Rich Coffman

Tel: 617-951-5311

Email: RMCoffman@wellington.com

UK and Europe

Bob Sharma

Tel: 44-20-7126-6068

Email: BSSharma@wellington.com

This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.