In 2022, pension funds that had an allocation to hedge funds benefited greatly, with hedging playing a key role in shoring up plan performance and delivering above positive returns amidst weak overall market conditions. Because of this, we believe, that after a decade of bull markets, hedge funds are being rediscovered as an important diversification tool for a complete portfolio.

But what are the different ways to construct a hedge strategy and how do they compare?

For simplicity, let’s look at the universe of hedge fund strategies into two ways:

1.      Long-biased funds -  commonly found in equity, credit and activist strategies. These strategies employ a “market plus” philosophy and aim to capture a greater proportion of market upside than downside. These strategies benefit from economic growth and are popular with risk-seeking investors.

2.      Market neutral funds, - these employ an “all weather” approach that seeks to be uncorrelated to stock markets, include commodity trading advisors and relative value arbitrage strategies like statistical and volatility arbitrage.

Market neutral investors seek a consistent excess return over cash with low volatility and with downside protection.  To do so, they prioritise true alpha (returns driven by idiosyncratic rather than market risk). These strategies are often difficult to implement successfully and will employ sophisticated investment methods and risk management tools. This “all-weather” style tends to underperform during periods like the post- Great Financial Crisis (GFC) bull market but may enjoy renewed interest today as higher interest rates and an equity bear market confer renewed interest in market neutral mandates.  

Note: Long-biased strategies include Equity Long/Short and Event Driven strategies ex-equity market neutral and short biased equity strategies; market neutral strategies include macro, relative value, equity market neutral, and short-biased equity strategies

Unsurprisingly, pension funds tend to favour market neutral mandates with an emphasis on macro and multi-strategy funds. Futures trading, relative value, quantitative, and low net equity strategies are also used to craft a diversifying return stream. This bias served the pension community well in 2022, as pensions have outperformed all other types of allocators in their hedge fund allocation.[1]

Strictly speaking, a rigorous market neutral approach excludes all strategies with long-biased exposure. However, in practice, many “market neutral” programs incorporate modest allocations to long-bias strategies to add new sources of alpha. The guiding principle is flexibility to allocate to differentiated long-biased strategies while maintaining core exposure to uncorrelated strategies.  

Recent structural innovations have increased the variety of ways to access hedge fund strategies. Let’s look at three approaches: multi-manager hedge funds, in-house hedge fund allocation programs, and funds of hedge funds.

Multi-manager funds feature multiple portfolio manager teams with a centralised CIO who allocates capital and imposes risk management across the PMs. Funds may engage in multiple strategies – relative value, event-driven, equity long-short and macro (“multi-strategy”), or purely equity long-short. Top-down risk management makes it feasible to employ higher leverage and still contain downside, ideally. On the other hand, these funds sacrifice some strategy diversification and may pass through expenses, resulting in higher fees.

A potentially more comprehensive way to build a hedge fund allocation is to develop an in-house investment program comprised of many individual funds. However, this requires a commitment of staff to select and monitor funds - this is perhaps an option for larger organisations looking to establish proprietary expertise in alternatives but not an option for most schemes. The payoff for the high upfront expense comes from new relationships, expanded market insights and eventually a program customised to meet the organisation’s objectives.

A faster and more economical path to diversification is via funds of hedge funds, where an investor buys into an existing portfolio of many individual hedge funds selected by an experienced portfolio manager. The portfolio manager leverages his, or her, experience to select the best value for fees and may source managers from across the spectrum of hedge fund strategies. Historically, funds of hedge funds have been used as a stepping-stone towards the ultimate goal of creating an in-house program.

This table demonstrates the pros and cons of each approach in a market neutral context, according to analysis we have undertaken.

What’s clear is that market turmoil across multiple asset classes in 2022 impacted many pension portfolios across the UK – in some cases for better, in others for worse. The search for diversification is ever on for schemes. Hedge funds, , particularly market neutral hedge fund mandates, are a really sensible way for UK pension funds to integrate some alternative diversification into their portfolios. These mandates carry unique return characteristics and utilise some of the most sophisticated investment methods available in the marketplace today – we would urge pension funds to strongly consider them as a tool in their armour.