The hedge fund edge: Picking winning managers

In recent years, many hedge funds have failed to live up to one of their promises; to deliver strong absolute returns with low correlation to more traditional asset classes.

Instead, investors have seen lacklustre returns that, at times, have been highly correlated to both equity and bond markets. As a result, it has become increasingly difficult for managers to justify their fees.  

While it's true to say that fees have been falling over recent years, hedge funds are still significantly more expensive than more traditional investments.

The disappointing returns and increased scepticism over whether these high fees are justified has led a number of large US and UK pension funds to completely redeem their hedge fund allocations.

Some also decided that the resources and expertise needed to manage these allocations was simply not worth their time and effort. This was particularly true for the larger pension funds who were just too big to ever scale the hedge fund allocations to a meaningful size.

However, despite this negative press, there remains some truly talented managers out there, generating consistent levels of outperformance with little to no correlation to more traditional assets.

Producing 'alpha'

Key to success is a manager's ability to produce 'alpha'. This skill-based measure represents the return produced over and above the markets they operate in.

Talented managers have been more astute at producing alpha by taking advantage of the flexible nature of hedge funds to better implement their strategies.

Skilful implementation of risk management techniques has also allowed the best managers to limit downside risks. Even at the industry level, drawdowns have often been shorter and shallower than those experienced by equity markets.

Turbulence is an opportunity

It is clear that good hedge fund managers can benefit schemes -  and their flexibility to take advantage of both up and down market moves as well as capture returns across a broader range of asset classes remains an attractive proposition.

By investing a portion of a traditional portfolio in good quality hedge funds, overall downside risks can be greatly reduced - especially in more challenging environments, such as a recession or period of high inflation.

Indeed, if a portion of a scheme's traditional assets were switched to a group of skilled hedge fund managers, their uncorrelated returns could help create an overall portfolio that is more resilient in these more challenging environments.

Surprise events such as Brexit, the Trump presidency and the ongoing political risk in Europe: these are all opportunities for a good hedge fund manager to take advantage of.

The key is being able to find them. 

Navigating the industry

The hedge fund industry can be a daunting place. It contains thousands of funds running a multitude of different strategies that exhibit a huge dispersion of returns every year. Good manager selection is crucial.

The problem a pension fund faces is that most managers are very experienced at writing good marketing documents and answering standard questions about investment objectives or fund liquidity.

But those that look good on paper can often turn out to be poor investments over the long term.

That's why a more unconventional approach can often better identify those who are likely to deliver consistent outperformance over time.

Understanding the individual

Gaining a firm grasp of how a strategy works and when it will both outperform and underperform is a must.

However, it is also essential to understand the individual behind the strategy.

The best investment managers share a number of character traits. These include an obsession for excellence, a passion for a challenge and a willingness to learn from mistakes.

Such traits help drive a firm-wide culture of continuing improvement and development, ultimately enhancing the ability to generate returns over time.

Assessing these traits can take hours of face-to-face meetings to understand the individual behind the strategy. However, it's an essential part of identifying world-class investment talent.

In summary, it's true to say that the hedge fund industry has not lived up to its promises in recent years. But there remains a select group of truly talented managers that have. You just need to know how to find them.

James Balcombe is a solutions specialist at Cardano

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• Hedge Funds
• Cardano