Why Hedge Fund Investing Is Key In Today's Market
Investors are turning to more exotic strategies as they seek to profit from the coming collapse of the current bull market. Stocks have had a good run since the 2008 financial crisis, which has made life simple for investors: buy the index and watch your investments rise in value. Conversely, the more complex strategies of hedge funds have not performed so well during the same period, as demonstrated by Berkshire Hathaway chairman Warren Buffett’s audacious bet.
For Buffett, this is proof that investors don’t need complex strategies. Simplicity is key. But while you probably shouldn’t argue with one of the world’s most consistently successful investors, many market watchers are forecasting an end to the current cycle and the beginning of a period that is more suited to hedging strategies.
“The investment environment is becoming more testing,” says Kevin Gardiner, global investment strategist at Rothschild & Co Wealth Management. “We are facing a mix of geopolitical tensions—some of which are novel—and a big slowdown in corporate profits. We think a constructive outcome is still plausible, but 10 years into a market upturn, conviction is in lower supply.”
Market analysts say a recession is unlikely despite slowing growth, and that it has typically paid off to stay invested even during the latter stages of a bull market. But that means being prepared for potentially big short-term falls as volatility rises. Indeed, December saw a big spike in stock market volatility as measured by the Chicago Board of Exchange’s volatility index, while 30-day volatility reached its highest point since 2011 in January.
“The investment environment is becoming more testing. We are facing a mix of geopolitical tensions—some of which are novel—and a bigslowdown in corporate profits.
So sitting back and watching the index rise may not be the best strategy for investors who want to maximise returns in 2019. “Growth hedges are quite attractive in this climate,” says Gardiner, describing a strategy where investors use bonds to help protect their portfolios during an equity sell-off.
“We find most government bonds prohibitively expensive, however, and are using more direct derivatives-based instruments and specialist contrarian funds.”
At this point in the cycle, some wealth managers are arguing that investors should be considering allocations to hedge funds as part of a diversified investment portfolio. “As we expect 2019 to remain volatile, hedge funds are an important portfolio component,” says Gunther Jost, head of hedge funds for Asia Pacific in the investment platforms and solutions team at UBS Global Wealth Management.
Jost says that in 2018, investors with allocations to well-selected hedge funds benefited from downside protection during the volatile months of the year, such as February and December, while getting a positive return well above the risk-free rate for the whole year. This is when hedge funds come into their own—providing the ability to protect investments when the market crashes, while still providing attractive returns.
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“Hedge funds can stabilise portfolios and offer exposure to uncorrelated and idiosyncratic return streams that are not captured by other investments in investor portfolios,” says Jost. “They are particularly relevant in less predictable markets due to their flexible investment approach that can generate returns independent of the overall market direction.”
“Hedge funds can stabilise portfolios and offer exposure to uncorrelated and idiosyncratic return streams that are not captured by other investments in investor portfolios”
— Gunther Jost
However, it is not always easy to pick the right hedge funds as there can be a huge difference between the best- and worstperforming managers in the industry. And some funds are difficult to get into for a variety of reasons. The bestperforming managers are particularly in demand and access often requires institutional investment size, industry connections, or both.
Jost recommends diversifying across different hedge fund strategies instead of concentrating on single strategies. Multistrategy funds with a relative-value focus or diversified hedge fund baskets should be seen as core portfolio holdings that can be complemented by satellite investments in other strategies such as long/short equity, trading and credit.
“In the current environment of uncertainty, we prefer managers with lower directionality or market-neutral approaches as they can limit the exposure to the direction of equity and bond markets,” says Jost. “Relative-value strategies that can exploit mispricing between different securities look attractive, as well as trading-oriented managers that can take advantage of macroeconomic changes around the globe.”
See also: Go For Variety: Diversification Is Key
- Illustration Bernard Chau