Hedge funds: A trusted companion on turbulent financial seas

Daniel Olivari, senior client investment specialist, Alexforbes Investments

The past few years have taught us that the world is an ever-changing and uncertain place. From unprecedented pandemics to geopolitical conflicts, global events have increased volatility in financial markets. Navigating these turbulent waters requires specialised knowledge and dynamic strategies to help steer investment portfolios through complex and changeable markets. In the realm of investments, hedge funds can serve as trusted sailing companions.

In this article, we explore how hedge funds can smoothly help guide investments while capturing opportunities and managing risks. We delve into their active management, flexibility and ability to deliver successful voyages, ultimately generating superior risk-adjusted returns for investors.

Understanding hedge funds: the art of investment navigation

Hedge funds offer unique skills and support, led by experienced asset managers who employ diverse strategies and techniques to successfully manoeuvre investments. These strategies allow hedge funds to chart a course through various asset classes and markets, providing a valuable source of risk-adjusted, absolute returns for portfolios.

Benefits of hedge funds: sailing towards success

1. Active navigation

Hedge fund managers actively manage their portfolios, making dynamic adjustments to seize investment opportunities and responding swiftly to market changes. Their proactive approach enables them to capture gains and steer clear of potential losses.

2. Flexibility and adaptability

Similar to ships changing course to avoid obstacles, hedge funds possess the ability to explore different investment strategies and asset classes, where appropriate. This flexibility allows them to respond to evolving market conditions and optimise portfolio performance.

3. Risk management

Just as trusted sailors anticipate and manage risks at sea, hedge fund managers employ sophisticated risk-management techniques to protect investments. Through hedging strategies and other risk mitigation tools, they aim to navigate volatile market conditions and safeguard the capital of portfolios.

Research and evidence: the navigator’s toolkit

Academic studies

Several academic studies have investigated the effectiveness of hedge funds. Metzger and Shenai (2019) analysed the performance of 10 major hedge fund strategies during and after the global financial crisis. The data sample was analysed for correlations, risk and return, consistency of performance and return attribution. They concluded that hedge fund strategies can generate superior returns and conserve capital for investors, particularly during periods of crisis. Additionally, Amin and Kat (2003) showed that hedge funds can improve the risk-return profile of portfolios when mixed with traditional investments.

Locally, research conducted by Muridili et al. (2022) assessed the impact of Covid-19 on the performance of hedge funds compared to mutual funds in South Africa. Their research concluded that hedge funds were able to perform better, from a risk-adjusted perspective, than mutual funds during the volatile market environment of 2020 (the Covid-19 pandemic period). Again, this experience demonstrates that integrating hedge funds into the mainstream component of traditional market-linked portfolios can enhance risk-adjusted returns and provide valuable diversification benefits.

Our experience

Since March 2000, we have successfully managed hedge fund of fund (HFoF) portfolios. The strategies aim to deliver improved long-term investment performance while minimising downside risk. Our analysis consistently reveals that incorporating dedicated allocations to these hedge fund strategies within a broader multi-asset approach can enhance risk-adjusted returns for investors.

Similar to global and local hedge fund research, our range of HFoF portfolios have demonstrated robust downside protection capabilities as indicated by significantly reduced maximum drawdowns during the analysed periods. Consequently, these portfolios have delivered superior risk-adjusted returns, exemplified by their elevated Sortino ratios. In other words, the performance of these HFoF portfolios has been exceptional when considering that they have achieved higher returns relative to the downside risk they have taken. This indicates that the hedge fund managers we have selected and blended within our HFoF solutions have effectively managed risk and protected the portfolios during market downturns, while still generating strong returns.

These findings underscore the value of integrating HFoF portfolios into an investment strategy, further solidifying the case for improved risk-adjusted returns for investors.

What investors should consider

In considering the inclusion of hedge funds in their portfolios, investors should prioritise partnering with a knowledgeable and experienced provider in this space. When looking to access hedge funds, several key factors should be considered:

Proven manager selection abilities 

Just as selecting trustworthy sailing companions is crucial for any successful voyage, investors should partner with a provider that demonstrates a track record of successful manager selection. Conducting in-depth research, evaluating track records and assessing risk management practices are essential steps to identify reliable and skilled sailing companions for portfolios.

Manager and strategy diversification 

Investors should seek a partner that offers a range of hedge fund strategies and managers. Diversification across different managers and strategies can help mitigate risks and improve the overall risk-return profile of the portfolio, resulting in smoother return streams and improving the likelihood that intended investment objectives will be achieved.

Strong relationships with asset managers

Trustworthy partners should have strong relationships with asset managers in the industry. These relationships allow for secure access to necessary services and information from the underlying managers. It also facilitates improved risk management and transparency, enhancing the overall investment process.

Fee negotiation and cost efficiency

As with any voyage, there are costs involved. Hedge funds typically charge higher fees due to their specialised expertise. However, the potential benefits and risk reduction achieved through skilled navigation may outweigh these costs. Investors seeking cost-effective and dependable allocations to this asset class should leverage a provider with scale and longstanding industry relationships. Leveraging these strengths, such providers can successfully break down barriers to entry and enable a wider range of investors to access the benefits of hedge fund investments at lower fees and governance budgets.

Daniel Olivari is a senior client investment specialist at Alexander Forbes Investments, joining in 2016. He holds a BBusSc (specialising in finance) from the University of Cape Town and is a CFA charterholder.