The mechanics behind an attractive alternative

With its built-in diversification across strategies, individual managers, markets and regions, the fund of hedge funds aims to deliver absolute returns decorrelated with traditional asset classes, but does so with limited volatility and controlled drawdown. During the past 20 years, a new initiative in alternative investment has been growing alongside traditional asset management. This trend has materialised essentially with the ability to hedge or offset some portion of the “long only” risk through vehicles usually referred to as hedge funds. Performance within traditional asset management is measured relative to market indices designated by the industry as benchmarks. These include the MSCI World, S&P 500, NASDAQ, FTSE 100, Nikkei 225 and JP Morgan Global Governmental Bond Index. For that very reason, the roaring global equity bull market of the late 1990s has allowed the traditional side to develop in a rather unsophisticated way, compared with the risk management tools developed by the investment banking and capital markets world. “Hedge funds have answered the growing need of sophisticated clients for diversification, absolute return and decorrelation with traditional asset classes,” says Arie Assayag, global head of hedge funds at SG Asset Management. “They have done this through applying the new tools of risk management, combining these with increasingly robust investment processes and drawing from past experience of excessive leverage,” says Mr Assayag. Since mid 2000, with the end of the global equity bull market, hedge funds and their decorrelated strategies and returns have attracted a broader investor base. And the offer of alternative products has also evolved in response to this demand. There are now two types of basic products. Single hedge funds have a specific focus on a strategy, an asset class, or a geographic area. Funds of hedge funds are more likely to be diversified across strategies, markets and regions. They provide an attractive alternative for the investor’s asset allocation because of their controlled risk and volatility. Strategies In general, hedge funds will create absolute returns through innovating investment strategies. It allows them to arbitrage markets or to invest more efficiently by quantifying the risk reward for each new position. Because the correlation between these three main strategies is low, a fund of hedge funds will use them as a way to diversify and efficiently monitor the risk/reward. The main objective of this new asset class is to deliver absolute return with limited volatility and controlled drawdown (ie, Pick to Valley). Merits As a case study, we will use the historical performance of the SG AM Alternative Diversified Fund (SADF), SG Asset Management’s fund of hedge funds. This programme was initiated in early 2000 to provide Société Générale’s clients with a diversified product, delivering absolute returns decorrelated with traditional asset classes. To achieve this goal SG AM has brought together market expertise, advanced quantitative techniques as well as other company resources. To this regard, the study of the sensitivity of SADF returns to market and economic factors is interesting. Given the very nature of the trading techniques, linear risk models reflect inaccurately the existing relationship between hedge funds’ performance and fundamental risk factors. SG AM’s hedge funds research team uses non-linear models because they better fit those relationships. In this approach, we measure the risk premium of a fund of hedge funds as the spread between the fund’s monthly returns with the one-month LIBOR rate. This spread is a good indication of the risk taken by an investor, and is used to evaluate the fund performance. In this kind of analysis, several fundamental factors can be used such as the S&P 500 Index, or other relevant indices investing in fixed income or commodities. In the following example, we have analysed the behaviour of SADF with respect to US equity market returns and volatility, measured respectively by the S&P 500 Index and the VIX Index. The study is based on SADF monthly returns between January 1993 and December 2002, using pro-forma performance between January 1993 and September 2000, and actual returns since October 2000, inception date of the fund. Analysis These results (see chart 1) demonstrate that a well-diversified fund of hedge funds will have a good upside capture in bullish markets. In bearish markets, it will achieve capital preservation for investors and good positive performance when the volatility as measured by the VIX is below a threshold. These objectives could be achieved with controlled drawdown and lower volatility, when compared with traditional asset management products. More specifically for SADF, when markets are bullish and LIBOR is usually high, such a combination of strategies can achieve a 15 to 18 per cent target average annual return over a three to five year horizon with reasonable volatility. In the environment we have since 2000, characterised by bearish equity markets, low interest rates and high risk aversion among our customers, the main goal of a diversified fund of hedge funds is to preserve capital, putting more focus on volatility and drawdown control. The targeted returns in such an environment should be around 6 to 8 per cent (ie, LIBOR + 400-600 basis points) over the investment horizon. We spoke briefly about performance and volatility targets achieved through diversification and optimisation of the strategic allocation in the main three strategies (ie, equity hedge, global macro/CTA and relative value). In addition to diversification and strategic allocation, a large part of the value creation resides in the dynamic allocation and the manager selection. By experience, 200-300 basis points can be added to the annual performance of the fund with a good hedge fund selection and the alpha creation (ie, absolute return) generated by those managers. The dynamic allocation is the result of a fund of hedge funds manager’s ability to calibrate and refine the allocation in the main and sub-strategies, based on his market forecasts and expected strategy returns in a given environment. The dynamic allocation could imply substantial variations from a long-term optimal allocation. A fund of hedge funds team will demonstrate its value mainly in its ability to acquire the best managers, hedge funds with consistent and robust performances, proven track records and expertise. These rare gems will be closed most of the time to investors. The temptation to invest in inexperienced managers, in early life cycles, (ie, first three years) when they are usually more aggressive in their returns, will be greater. However, by investing in the short track records of less experienced managers, investors will bear additional risks. The rate of success of evolving managers is very low and getting lower with the recent growth of the industry. Since inception, SADF has taken a conservative approach to exclude managers with less than three years of robust track record and limited assets under management. It focuses on the acquisition of the most experienced ones. Chart 2 demonstrates SADF value creation first from a long-term optimal strategic allocation in the three main strategies; and second from dynamic allocation and manager selection. Benoit M. Ruaudel & Eric M. Attias, portfolio managers, SG Asset Management