April 5, 2023
Hedge funds may be an appealing investment alternative in times of financial uncertainty, but companies should take a strategic approach when adding them to portfolios.
Key takeaways:
- Hedge funds can help organizations in diversifying their portfolios, but it’s important to define goals for the investment and view the portfolio through a holistic lens.
- The consequences of unforeseen events and market volatility should still be considered when planning to invest in hedge funds.
- As with all portfolio management, hedge fund investment requires high levels of engagement, research, strategy and risk management.
Overview
As companies seek to achieve their investment and pension goals in a complex and rapidly changing economic environment, many are exploring alternative investments to add to their portfolios — including hedge funds.
“If you look at the long-term history of markets, the volatility we see today is much more normal than the previous period of relative calm and inexpensive financing, which really created a tailwind for equities and bonds,” says Chris Walvoord, global head of alternatives portfolio management and research at Aon. “Today’s environment, including rapidly rising rates, is actually a return to normal. That may create new opportunities.”
Strategies for hedge funds vary greatly from long/short equity to event-driven approaches, among others, and hedge funds invest in a broad range of securities and assets. While hedge funds can enhance a portfolio, they also require a thorough understanding of market volatility.
“By sourcing returns from something other than the equity and bond markets, hedge funds provide diversification and value, but companies will need to look at their portfolios as a whole and manage risk appropriately,” says Walvoord.
In Depth
As with all investment strategies, companies should consider their whole portfolio, risk tolerance, risk management and their ultimate goals and timelines. No strategy can avoid every loss or anticipate the unknown, but there are ways to manage exposure and approach decision making. There are several considerations companies should make before they explore the role of hedge funds in their portfolios.
Typical Hedge Fund Approaches
There are a few ways companies typically think about how hedge funds fit in their portfolios, says Walvoord. “One approach is to allocate a portion of the portfolio, say a given percentage, to strategies that provide diversification, which includes alternatives like hedge funds,” he says. “We also see companies essentially mix hedge fund strategies into their other allocations — bonds and equity.”
One of the key considerations investors should make before investing in hedge funds is establishing expectations. “You want to define the purpose of the allocation so the approach you take helps accomplish your objectives,” Walvoord says, as there are a wide range of risk and return characteristics across the hedge fund universe. “If you have a diversifying allocation within your portfolio, there should be an overarching purpose for those investments. A lot of it comes down to how you benchmark these hedge fund strategies. Though they don’t always fall into conventional preexisting categories, if you can apply similar benchmarks, that can work as you understand and track how you’re accomplishing your objectives.”
Managing Volatility
While today’s financial volatility is likely to continue — driven by geopolitical tensions, higher financing rates and inflation, among other factors — this also presents opportunities for diversification when it comes to managing investment strategy and risk.
When larger disruptive events occur in the market, they often highlight the risk management approach taken by institutions and funds — something that’s not as visible in periods of relative calm. “For periods like this, we have to take them as learning opportunities,” says Walvoord. “When we’ve had a number of unanticipated events that have introduced further volatility and caused damage for some participants, risk exposure and management is far more evident. In these periods, we need to refine our preferences and choices based on what we learn.”
Considering Investment Strategy and Oversight
No matter the makeup of an organization’s portfolio, the key principles in maximizing long-term returns and responsible management are the same — market research and insight, viewing and managing the portfolio in a holistic way, proactively managing risk and understanding and balancing a range of risks and opportunities. “For investing in hedge funds in particular,” says Walvoord, “Companies need a higher level of engagement and education of the board. It’s added responsibility that requires knowledge, research and understanding,” Walvoord says.
Companies should ensure they have the right people and processes in place for dedicated expertise and research, an in-depth understanding of their own risk tolerance and their framework for decision making and management to view the portfolio as a whole, including understanding how different strategies fit together and how they are achieving the company’s goals. Some boards may have dedicated teams, or they may consider an outsourced chief investment officer (OCIO) to manage investments and governance.
“When looking at the portfolio as a whole over time, companies should consider the purpose hedge funds and all allocations serve in the portfolio. Sometimes the returns will be lower, but they still serve a purpose. Thinking through that takes time and diligence along with research and strategic decision making,” says Walvoord. “Being able to really take a step back and take a holistic look at your portfolio and think about what each allocation is trying to achieve and how you should build it is key, and one of the important ways to maximize your long-term potential.”
To find out more about Aon’s insights for investing in uncertain times, click here.
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