Hedge Funds: Slow and Steady Wins the Race
March 27, 2023 - HighGround Advisors is moving from a fund of hedge funds to a direct portfolio. But why? And what exactly IS a hedge fund? HighGround Director of Public Markets Steven Thieme shares his expertise about the asset class and HighGround's approach to investing in hedge funds.
WHAT ARE HEDGE FUNDS?
A hedge fund is a vehicle used to access investments. Hedge funds are pooled investment funds, like a mutual fund or an Exchange-Traded Fund (EFT), however, that is where most similarities end. Hedge funds are set up through limited partnership (LP) vehicles and can only be accessed by sophisticated, institutional investors and their advisors. While mutual funds and EFTs typically utilize a straight-forward investment process of buying stocks and bonds, hedge funds often utilize complex investment strategies that can buy nearly any type of asset - long or short - including stocks, bonds, real estate, commodities, or currencies. In fact, a well-known hedge fund once acquired an Argentinian navy ship as collateral for a debt it was owed!
Another unique feature of hedge funds is the use of leverage. Leverage is essentially borrowed money that increases exposure to magnify returns. Hedge funds have no limits on their ability to use leverage.
Most often, hedge funds are intended within portfolios to limit the market’s systematic impact on performance by hedging out a portion of the market’s risk. Unlike publicly traded stocks and bonds, where the main drivers of returns are market movements, a distinguishing feature of hedge funds is that their performance over time is primarily driven by a manager’s ability to generate returns through specific strategies that are largely uncorrelated to the stock and bond markets. Types of hedge fund strategies include equity long/short, event-driven, global macro, managed futures, and multi-strategy.
WHY INVEST IN HEDGE FUNDS?
Hedge funds provide differentiated sources of return not otherwise available in traditional stock and bond investment strategies. The primary reason to invest in hedge funds is for diversification. Historically, hedge funds have often zigged when the market zagged. For example, for calendar year 2022, the HFRI Fund Weighted Composite Index was down 4.5% while the S&P 500 Index was down 18.5% and the Bloomberg US Aggregate Bond Index was down 13.0%.
Diversification improves downside protection during market stress periods, enhances long-term risk-adjusted performance, and reduces overall portfolio volatility. In the example above, exposure to hedge funds resulted in lower volatility, higher returns, and a higher Sharpe ratio.
HOW DOES HIGHGROUND INVEST IN HEDGE FUNDS?
There are two main ways to build a hedge fund portfolio: 1) by investing through a fund of hedge funds, where management of the hedge fund portfolio is outsourced to an investment manager, or 2) by building a direct hedge fund portfolio internally. HighGround historically invested through a fund of hedge funds but has been building a direct hedge fund portfolio since the start of 2023. With the elimination of the underlying fund of funds managers, investment performance could potentially be improved. The move from a fund of hedge funds to a direct portfolio offers several additional benefits, including:
Potential for improved manager access
The difference in returns between top and bottom quartile hedge funds is large, making manager selection and access vital. HighGround’s ability to access top tier hedge funds is improved by going direct, as our investment size is much smaller than the typical fund of funds investor. Top hedge funds are capacity constrained, meaning they can only manage a finite amount of capital before returns are adversely impacted, making it difficult for investors with large dollars to gain access. Additionally, our underlying mission and client base make us a partner of choice for top tier hedge funds.
Elimination of “diworsification”
“Diworsification” is a term coined by legendary investor Peter Lynch to describe the process of adding portfolio investments that worsen the risk-return tradeoff. This happens by investing in too many assets with similar correlations, which results in an averaging effect - essentially garnering average performance.
More Targeted Asset Allocation
Lastly, we can be more targeted in our asset allocation decisions through a direct portfolio. This is important as it allows us to steer clear of boom-bust strategies, like global macro and volatility arbitrage, and focus our efforts on strategies and managers that can consistently compound capital.
The overall goal of our hedge fund portfolio is to consistently compound capital and generate attractive absolute and risk-adjusted returns over full market cycles. Our approach is similar to the tortoise in the classic fable The Tortoise and the Hare – slow and steady (with consistently compound returns) wins the race.
To achieve this, we utilize a core-satellite approach in constructing our hedge fund portfolio. Our core managers will be the bell cows of the portfolio and will have a low correlation and beta to equity markets with fixed income-like volatility. Exposure to core managers will make up the majority of our portfolio. Satellite managers will be more targeted – either through a strategy type, a region, or a sector. We expect equity-like returns with downside protection from our satellite managers, though beta will be higher than core managers.
HOW DOES HIGHGROUND SELECT MANAGERS?
Manager selection is very important when it comes to constructing a direct hedge fund portfolio. The performance between top and bottom quartile managers can be significant. HighGround is focused on accessing top talent as we build out the hedge fund portfolio. There are several guiding principles that we utilize when sourcing managers, including:
Past performance is not indicative of future results, but past risk behavior is. Until proven otherwise, we assume prior drawdowns will happen in the future.
“Make money by not losing money” is a mantra we have that refers to the math required to make up for a large loss. For example, if a manager starts with $100,000 but loses 50%, they must now make 100% of $50,000 before an investor is back whole. If instead, the manager with $100,000 loses just 5%, they only need to make back about 5% of $95,000 before an investor is whole.
Alignment of Interests
We look for managers that “eat their own cooking,” with a significant personal investment in their funds.
As mentioned above, we believe that you win with talent, and we are focused on accessing hedge funds that have demonstrated an ability to compound capital while being prudent managers of risk.
Hedge funds thrive during periods of market volatility, and our recently approved hedge fund managers are well-equipped to take advantage of the current banking sector turmoil. If you have any questions about hedge funds or how HighGround's investment funds can grow your assets for good, call our investment experts today at 214.978.3300.