ACTIONABLE ADVICE FOR FINANCIAL ADVISORS: Newsletters and Commentaries Focused on Investment Strategy

Follow us on

Content Channels

Most Popular This Month

Most Popular This Year

New Strategies in Alternative Investments

November 9, 2010

by Robert Huebscher

The future of hedge fund strategies

Is it time for all advisors to embrace alternative strategies?  Not so fast, Welch said.  Since the financial crisis, the requirements for due diligence on hedge funds are much higher and a lot more expensive, partly due to the Madoff scandal, which made the understanding of the operational and back-office mechanics of a fund extremely important.  In fact, Welch said, researching and monitoring hedge fund operations is now a growth industry of its own.

Analyzing hedge funds is more difficult because the weaknesses revealed during the crisis (e.g., reliance on leverage) can be hard to identify and assess.  Indeed, Welch wanted to rename absolute-return strategies “levered credit” strategies for internal purposes, but he decided against this – when persuaded by his team that nobody would invest in a strategy with that name.

For advisors willing to wade into alternatives, Welch advocated a core-satellite approach.  The core should consist of “cheap and liquid” products, he said, such as long-short, managed futures and hedge-fund replication mutual funds.  These mutual funds are likely to underperform their limited partnership brethren, because they will use little, if any, leverage. 

The selection among these mutual fund products is sparse, and many have limited track records, he warned.  That said, according to Welch they represent the next generation of hedge fund strategies, and they offer the promise of bringing the benefits evident in the 20-year track record to a vehicle that has complete liquidity, near-complete transparency, and the absence of onerous minimum investment requirements.  For now, though, the limited track record of these vehicles makes the assessment of their long-term viability problematic.

The satellites can be individual strategies selected based on their perceived ability to produce alpha, according to Welch.  These can be funds-of-funds or they can be individual funds – assuming, he said, that you have a better-than-average ability to pick active managers that will deliver alpha.

Hedge fund critics can respond to many of Welch’s claims.  They will note, as Welch acknowledged, that reported hedge fund data is notoriously unreliable.  It is riddled with survivorship bias (funds stop reporting when their performance deteriorates) and backfill bias (new funds don’t report until their performance reaches an acceptable threshold).  

Perhaps more importantly, a primary vehicle for advisors – funds-of-funds – does not completely align the interests of underlying funds with investors.  A fund with a mandate to provide superior long-term performance should – and will – put up barriers to prevent individual investors, who typically cannot endure short-term volatility, from redeeming their investments.  This discourages the best hedge fund managers from participating in funds-of-funds.

Undoubtedly, the hedge fund universe has attracted the most talented managers.  Compensation is much higher at hedge funds than in the mutual fund industry, and managers do not have to deal with the pressures of daily redemptions.  Whether that translates to superior performance for advisors and their clients, net of fees, will depend on a number of factors – which must be uncovered through the due diligence process that firms like Fortigent undertake. 

Skeptics will claim that it is no easier to identify an outperforming hedge fund manager than it is to identify an outperforming mutual fund manager – and the latter is notoriously difficult.   But the benefits evident in the 20-year track record make it difficult to dismiss alternatives as a valuable addition to any portfolio.