Manager selection is critical when adding a hedge fund to a portfolio, says Towers Perrin head of research Dennis Sams.
“The spread between good and bad (hedge fund) managers will kill you,” he says. “The manager must have a wide dispersion of returns and a clear alpha generation process.”
Risk control is another important issue when implementing an absolute return strategy into a portfolio, Sams says.
“You don’t want to eliminate risk, but you want to know what risk you have (in the fund),” he says. “There can be abnormal risks such as hidden beta or correlation changes.”
Other risks include ‘style drift’ by a manager, which is where the hedge fund moves away from the initial investment strategy of the fund.
There can also be an increased risk from breaches of compliance regimes and Sams says the superannuation fund trustees must make sure they have a sincere compliance structure in place.
Despite the potential upside on risk when using a hedge fund, Towers Perrin still believes it has a role in active return in portfolio construction. “We suspect risk has been misunderstood as there is a role for dynamic risk management,” Sams says. “Greatly increased levels of active risk results in increased returns.”
Another question when using hedge funds in portfolio construction is whether they are long-term strategies, he says. “Our view is they are long term, for the next 10 years, and then we will re-assess the portfolio,” Sams says.
“That means there are roles for a balanced manager and a market-timing manager and some hedge funds are now doing that.”
