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Hedge funds set to blossom in 2007

Hedge funds develop deep roots Hedge funds are here to stay. Not only are larger numbers of institutional investors committing to this sector but hedge fund investment techniques are increasingly being adopted by traditional asset managers. Those who are cautious about hedge funds voice concerns about risk levels, lack of transparency, low liquidity levels and high fees, but the attractions of high returns and low correlations are highly persuasive. Therefore, it is important when selecting a manager to find one who offers education about the strategies employed and explains their investment approach clearly. For those investors who have taken the plunge, risk remains a key focus. However, rather than being a concern, they are actually employing hedge funds to mitigate the risk in their portfolio. In Mercer Consulting’s 2006 global survey on funds of hedge funds investing, investors who have made investments into hedge funds have done so to either provide: “an equal combination of portfolio risk reduction and return enhancement or primarily for risk reduction” In addition, having sampled these strategies, 53 per cent of respondents expected to increase their allocations over the next two years, with the median hedge fund allocation expected to increase from 5 per cent to 7.8 per cent over the same period. Thus what should we understand before considering an allocation?

Moving from relative to absolute

Balance skill with market risk It is crucial in sub-advisory investment management to pick managers that can offer clients the highest likelihood of strong consistent returns. While great care is always taken over assessing managers’ philosophy and process (in order to build up an idea of potential future performance), less time is typically spent on ensuring that the manager has the opportunity to apply that skill in as many areas as possible. Last month, we addressed how relaxing the long-only constraint on equity portfolios can enable managers to fully express their negative, as well as positive, views on a stock. This may enable skilful managers to increase the target returns per unit of risk (indicated by a higher information ratio). This month we examine new approaches which can be taken in the global fixed income and currency market that provide investors with access to manager skill while seeking to mitigate market risks.

Getting more out of equity portfolios

Loosening the constraints How do some equity fund managers make more money than others? The essential principle is easy to understand: buy the right stocks at the right time and you should generate outperformance. But how do managers structure these multiple stock bets to create equity portfolios with the ability to access the highest potential returns? Traditionally the approach has been to take fewer bigger bets, constructing a more concentrated portfolio. This means a fund with just the stocks the fund manager really likes – their high conviction ideas with the strongest upside potential. However, the concentrated nature of these portfolios also means that they experience high levels of volatility due to the increased level of risk. Is there an alternative which can be offered to meet the demand for strong fund performance but with potentially less risk exposure? Can’t high returns be created from a more diversified portfolio?

Breaking the long-only barrier

loosening the constraints Investment managers face many different constraints, usually in the form of investment guidelines. Some constraints are necessary and desirable, like having a risk budget for an investment mandate. Others are less desirable such as those imposed by the markets themselves. Perhaps the most restrictive of these various constraints is the no shorting rule, as it dramatically reduces a fund managers opportunity set for investment. It is likely that investors can realise a potentially large alpha benefit by relaxing the long-only constraint, i.e. no shorting in an equity portfolio. This benefit arises from the market-cap weightings of standard equity benchmarks and the long-only portfolio manager’s inability to profit from negative views on companies with low index weights.

Managing the mix for best results

Best in class Last month we discussed the challenge of building the correct asset allocation structure. This month we discuss how those assets can be managed to provide the best service for your clients. In the UK, over the last three to five years, open-architecture delivery of investment through third-party distribution of mutual funds and sub-advisory relationships has revolutionised access for investors to top-performing managers and funds. It provides access to one-stop shopping and enables more consistent and robust product due to the ability to change investment content. However, it is surprising that the associated benefits are still not universally accepted. The investment decision is crucial to the investor and eclipses the value of most other forms of advice given to clients – even taxation, given consistent reduction of tax benefits across investment products. Yet, despite the importance of this decision, investment remains a small part of the advice given to clients, with the majority of time spent on advising which wrapper to use – be it an Isa, bond or unit trust rather than which fund can best meet their investment needs.

Limiting risk and boosting returns

Benefits of diversification When constructing a portfolio, two main challenges present themselves – picking the right asset classes and then picking the best managers to run those assets. Choosing an asset allocation strategy can help protect you from downside risk as well as helping to ensure that you maximise the benefit from potential upside. Interestingly, diversification is one of the few elements in a portfolio that is also free. A strong investor can optimise their approach using the diversification tool. The last few weeks have exposed how quickly the direction of the markets can change, and investors’ risk appetite with it. It is moments like these that highlight the importance of protecting your client’s assets by holding as diversified a portfolio as possible. For example, while equities remain an attractive asset class with a return premium (over cash) of around 3 per cent per annum, they carry with them an annual volatility of 15 per cent, which can make your portfolio returns highly variable. It therefore makes sense to branch out into asset classes that don’t all behave alike, but can provide similar levels of return expectation. This is indicated by the correlation. For instance, if you add North American equity to a UK equity portfolio, the correlation is relatively high at 0.74; they behave in almost the same way (complete correlation being 1.0). Choose global high yield bonds instead (correlation of 0.36) and there is less likelihood of the two moving in sync and more likelihood of the combination working together to yield more robust returns. Combining multiple asset classes with a low correlation to each other has the potential to result in a more efficient portfolio, limiting your total risk and providing better opportunity for positive returns.

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Quantitative funds: a clear decision

The rise of quantitative managers
Since the late-1990s, there has been substantial growth in the amount of assets managed by quantitative managers and using quantitative investment strategies in the institutional fund management arena. In the last several years this rapid growth has continued, as client demand has bifurcated between higher octane high alpha products and lower tracking error index plus products. Fund buying professionals are clearly looking for well-managed quantitative equity funds to put at the core of their client portfolios. Such funds enable fund buyers to reliably put in place what they hope are consistent asset class returns, often outperforming index tracking products, to construct successful portfolios and investment products.

Boldly entering the alpha universe

The four powerhouses of the future

Dr David Curtis, head of GSAM’s European Sub-Advisory business, discusses investment solutions

Taking advantage of the opportunity to add commodities to your portfolio

Portfolio challenges It has long been recognised that investing in commodities can offer several benefits to a portfolio, including negative correlation to stocks and bonds and historically higher index returns. However, due to past legislation, such investments were only available to institutional investors. With the advent of Ucits III this has now changed and a more widespread investor base is able to consider the benefits of investing in commodities.

Global Private Banking Awards 2022 Highlights

More than 120 banks from 50 countries around the world entered this year’s annual global private banking awards. 19 of those entrants have won more than one award. Of these, six institutions - including Citi Private Bank, BTG Pactual, Erste Private Banking, HSBC Private Banking, Northern Trust, Itaú Private Bank – gained the top position in three categories each. Video highlights from the 2022 Global Private Banking Awards.

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