Portfolio > Alternative Investments > Hedge Funds

Alternatives to the Rescue?

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The Frenchman Jean-Baptiste Alphonse Karr must have been thinking about something besides finance when he mused that “the more things change, the more they stay the same.’’ Financially, the more things change, the more things really change. Just a few years ago, we thought diversified portfolios would protect investors. We thought markets were efficient. We assumed consumers behaved rationally.

The 2008 crisis led to lots of rethinking about finance and investing, including rethinking hedge funds and the role they can play in both institutional and individual portfolios. To wit, and contrary to their reputation, we now look to hedge funds to provide sophisticated risk management for institutions. At the other end of the scale, we see the marketing of hedge funds moving to a new level, making them more accessible to retail clients. Thanks to the introduction of “liquid alternatives,’’ a hybrid of mutual funds and hedge funds, and to less restrictive rules under the JOBS Act, investment advisors no longer have to buy expensive databases or hire consultants just to ferret out the names of hedge funds.

As they have undergone this transformation, hedge funds have left their gunslinger image behind. Increasingly, they offer transparency so their investors can monitor positions. They take governance seriously, appointing outside directors who represent the interests of investors. Their operations are evolving to meet the demands for higher-quality reporting and infrastructure. What these changes mean is that hedge funds can now play an important part in portfolio construction. It’s an opportunity that investment advisors should consider.

Hedge funds were originally boutique investments for the very rich—secretive pools whose managers swung for the fences with abandon and turbo-charged their long-short portfolios with leverage. Even when they were adopted in the 1980s by college and university endowments, it was for their skill in beating the market benchmarks, what the industry calls “alpha.’’ Once the news got out about Yale and Harvard’s success with hedge funds, pension funds jumped on board, with big institutional investors like California Public Employee Retirement System leading the way in the early 2000s. Money poured in through 2007 as institutions tried to match those outsized returns.

Then 2008 hit and there was nowhere to hide. U.S. private pension funds, to pick a proxy for the damage done to portfolios, suffered real losses of 26.2%. While the 2008 crisis will supply topics for Ph.D. dissertations for years to come, not all of them will be gloomy; 2008 provided valuable lessons.

“Out of the ashes emerges a new phoenix of financial innovation. That’s really the nature of progress,” as Andrew Lo, professor of finance at MIT Sloan School of Management, put it in a recent CFA Institute magazine interview.

Today, hedge funds’ assets under management total $2.3 trillion, an amount that surpasses their pre-2008 record of $1.9 trillion. It’s still only a fraction of the $64.2 trillion of AUM worldwide, but more important than their AUM is the way hedge funds are now regarded. Once small tributaries to the river of finance, hedge funds are now a major source of innovation and solutions.

It makes sense. From the beginning, hedge funds have attracted some of the brightest minds in the investment business, lured by the chance to make millions or billions, thanks to their compensation model. Only Silicon Valley start-ups can match the opportunity to create fortunes as fast. But a bifurcation is taking place between small and large hedge funds. Because smaller hedge funds can be more nimble and their managers are perhaps hungrier, they tend to pique investor interest.

But one surprise is that a certain kind of innovation is coming from larger hedge funds. These are the $1 billion-plus funds that have developed some of the most sophisticated risk management tools in finance today. For these hedge funds, it’s not about individual “genius’’ managers anymore—it’s about avoiding losses. Of course, there’s irony in viewing hedge funds as risk control experts, but if necessity is the mother of invention, credit the cascade of institutional money for driving the risk management process. It’s one thing to strive for absolute returns in a classic long-short equities hedge fund with $200 million in assets. It’s quite another to handle $81.9 billion at Bridgewater Associates or $43.2 billion at Man Group or $39.7 billion at Brevan Howard Capital Management, to pick the world’s three largest.

These and other large hedge funds have found a way to manage downside risk using derivatives—an esoteric brew of contracts, options and swaps. If they buy sovereign bonds for their relatively high yields, they may also buy credit default swaps to mitigate risk in the event that the issuing government defaults. If they think a country’s growth rate is slowing, instead of shorting the stocks of companies that supply, say, oil and coal to that country, they may buy credit default swaps on those companies’ debt. Of course, as with any investment, derivatives are subject to their own set of unique risks, including the risk that the hedging strategy may not produce the desired results.

Hedge funds’ growing sophistication in handling risk is bringing in even more assets from pension plans and retirement systems. It’s a key reason why the big hedge funds are getting bigger. (Hedge funds with $1 billion or more in assets make up only 20% of the industry, but they control 90% of the assets.) As I wrote in a previous commentary, some chief investment officers of corporate and private pension funds think hedge funds should have an even bigger role. Rather than allocating 10% or 20% to hedge funds, they’re recommending that entire portfolios be turned over to hedge funds so that they can take advantage of their risk control mechanisms.

[For more on hedge funds in pension plans, see “State Pensions Seek Higher Returns Through Alts.’’]

Innovation is also redefining and expanding ideas about what constitutes an asset class. If nature abhors a vacuum, finance abhors an inefficiency. The discovery of inefficient markets—and it’s often hedge funds that discover them—keeps refreshing the array of investment opportunities for investors.

One niche class to watch is lending. This area has seen an influx of hedge fund money in 2013. As banks have retreated from this space, hobbled by mortgage losses and tougher capital requirements under Dodd-Frank, hedge funds like D.E. Shaw Group and Oaktree Capital Management have moved in. Both set up funds in 2013 to lend to small and mid-sized businesses. Not only are banks hesitant to lend, but they are also trying to sell billions of dollars’ worth of soured loans to clean up their financials. One way to unload loans from a bank’s balance sheet is to sell them to investors—another way hedge funds are moving into the credit space.

Infrastructure is another investment niche making a bid to become its own asset class. The combination of governments pinched for cash, low interest rates and demand have created opportunities for hedge funds to invest in big-ticket projects like airports, highways, bridges, ports, power plants and pipes, just to name a few. It’s a similar story with cleantech and greentech.

The point is, whether it’s emerging market debt, another asset class, infrastructure plays or derivatives, hedge funds are often first to spot the opportunities. It’s true that for those who believe in passive management, exchange-traded funds also offer a way to invest in these alternative asset classes. But for investment advisors and chief investment officers who think active management gives their clients an edge, hedge funds may be a better fit for those with the risk capital to invest and an understanding of all the risks involved.

In the past, it has been a huge challenge for investment advisors to find hedge funds and to identify the good ones. That task is getting easier. Asset managers have introduced “liquid alternatives” for retail clients. Also called ‘40 Act funds, in reference to the Advisers Act of 1940 that created them, these are hybrids that combine hedge fund investment strategies with the potential advantages of a mutual fund. They have no income requirement, their fees are relatively lower and investors can buy and sell them daily. The sponsors of liquid alternative funds have done the hard work—they have found and vetted the managers. No surprise then that assets under management in liquid alternatives have jumped from $68 billion in 2008 to $279 billion in 2013, according to Morningstar.

Finally, the JOBS Act will make it easier for hedge funds and their investors to find each other. For the first time in their 65-year history, hedge funds are able to advertise to the public. The regulators have been ironing out final marketing rules, but beginning in 2014, investment advisors will be able to find and screen a broader array of managers.

The events of 2008 created a demand by institutional investors for more powerful risk control mechanisms. They also created a demand on the part of individuals for new sources of yield. How successfully hedge funds meet these two demands will determine their share of future portfolios.

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