The Next Wave of Hedge Fund Investing

The Next Wave of Hedge Fund Investing

By Adam Berger, Vice President, AQR Capital Management

There is growing division among hedge fund investors. Volatility, headline risk, lack of transparency and fees are driving skeptics away from the sector, while believers embrace hedge funds with renewed vigor. As the hedge fund industry evolves, both groups will find new investment products that meet their requirements.

For believers, the next wave will bring More, Better, Faster and Cheaper hedge fund investing.

More means getting more hedge fund-type strategies into the strategic asset allocation. Portable Alpha – which replaces traditional, constrained equity or fixed income managers with pure alpha plus a passive benchmark exposure – is one approach. Global Tactical Asset Allocation strategies, which have the potential to add significant returns with small capital allocations, are another.

Better means investing with higher-quality, institutional-strength managers. These managers offer returns that are truly uncorrelated with stock and bond markets; a thoughtful and intuitive approach to risk management; meaningful transparency and a stable business model to survive periods of tough performance.

Faster hedge fund investing means providing liquidity when it is needed. Institutional investors with long investment horizons are uniquely suited to be liquidity providers, and the rewards to this type of investing can be substantial. Investors can create a dedicated “opportunistic” slice of their hedge fund allocation or make pre-commitments to provide capital (on preferential terms) when unusual opportunities present themselves.

Cheaper hedge fund investing may seem like an oxymoron, but smart institutional investors may be able to pay less than other investors. How? First, by not paying incentive fees for beta. Second, by monetizing their long-term orientation and offering longer lock-ups for lower fees. Third, by investigating the small subset of “hedge fund replication” strategies that offer the diversification benefits of hedge fund exposure at lower cost.

For the skeptics – those who have held back (or pulled back) from the first wave of hedge fund investing – the next wave will include Alpha, Better Beta, and Cloning strategies.

Alpha for hedge fund skeptics means finding ways to get more efficient, less constrained alpha strategies – the ones that offer higher returns! – into their portfolios, without actually making an investment in hedge funds. “Relaxed Constraint” strategies (130/30, 120/20, etc.) are a natural way to do this, in some cases with the incumbent manager(s).

Better Beta is critical for investors who want to improve portfolio performance without allocating to hedge funds. Much of the appeal of hedge fund strategies lies in their low correlation to the stock and bond investments that make up the bulk of a typical portfolio. But there are other, non-hedge-fund strategies that also have this correlation advantage. Better Beta investors will rethink the range and scale of their market exposures to gain exposure to a set of global risk premia that is as diverse as possible.

Finally, Cloning refers to the hedge fund replication strategies described above. Although these strategies – when executed properly – may include some risks that skeptics would rather avoid, they may allow skeptics to make an initial foray into hedge fund strategies while sidestepping the three big pitfalls that drive skeptics away from hedge funds: headline risk, transparency and fees.

The fact that hedge fund replication is on the list for both believers and skeptics suggests that our “bifurcation” model is probably an oversimplification. Indeed, believers and skeptics want many of the same things – inexpensive, effective and intuitive strategies with low correlation to the rest of their portfolios.

The key objective for any investor is to determine where they fall on the skeptic-believer spectrum and let this shape their investing approach – spanning everything from setting policy and working with their governing board to choosing managers and hiring staff.

Transcontinental Media G.P.