Q: You’ve written a lot about hedge funds and liquid alternatives. It seems like the industry is in a constant state of flux. Can you talk about the biggest changes in the space over the past five years?
Andrew: I think the single biggest change is how allocators view single manager risk. Basically, it comes down to this: picking hedge funds is hard. Actually, really hard. If yesterday’s top decile performers were tomorrow’s, it would be easy. Instead, great performance sometimes is followed by brutal drawdowns. Faced with this reality, and in the absence of a crystal ball, institutions spread their bets across dozens of funds. Diversification of single-manager risk is key to hedge fund risk management.
Several years ago, when we first started to talk to investors about the SEI Liquid Alternative Fund, we were surprised to learn that many allocators would invest in only four or five single-manager funds. In some cases, since the overall allocation might be as high as 20%, each fund might constitute 4% to 5% of a client portfolio. To us, these highly concentrated portfolios seemed incredibly risky. It was as though allocators had put 20% into a few stocks.
From day one, our approach was quite different. Our ethos was to seek broad diversification— eventually, we settled on 70 target hedge funds—precisely because we wanted to minimize this “single-manager” risk. As a result, the initial reaction to the fund was that it was too “index-like.” For an allocator focused only on top performers, this seemed mediocre, perhaps even boring.
What a difference five years makes. A cascade of issues with former highfliers has underscored several hidden risks in single manager products: multiyear periods of underperformance, drawdowns far outside statistical bounds, and even gating/ suspension and swing pricing. Hence, by comparison, the risk mitigation of manager diversification has greater appeal
today. Arguably, “index-like” has become a compliment.
Q: When you use the term “index-like,” it seems to imply average performance. Yet the Fund ranked among the top decile of multi-strategy UCITS funds in the Kepler database. How do you explain this?
Andrew: Our business is based on a very straightforward concept: Replication of most or all pre-fee hedge fund returns delivers predictable alpha.
Five years ago, we struggled to explain this. As a starting point, it seemed impossible: Hedge fund alpha, almost by definition, was supposed to be “non-replicable.” Today, most allocators understand that there are various forms of alpha—some of which are replicable and some of which are not. It turns out that factor shifts are an important source of alpha and, helpfully, can be replicated. Plus, allocators seem to appreciate that some forms of non-replicable alpha—illiquidity premia, for instance—are not a one-way street: During certain market conditions, “alpha” goes negative. So, whereas “alpha” used to be a catchall term for returns that could not be explained by straight equity exposure, allocators now have a much more nuanced framework.
Today, we get very little pushback. What’s changed? First, most allocators seem to agree that hedge fund fees overall are too high—the evidence is clear that an alarmingly high share of returns, let alone alpha, is paid away. Second, allocators are more realistic about their ability to consistently pick the subset of funds that, net of fees, generate healthy returns. Finally, allocators now accept that “factor shifts” can explain a good deal of performance, perhaps because there have been such stark winners and losers in the smart beta landscape. Once allocators agree on those three points, replication of 80% to 100% of pre-fee hedge fund returns starts to sound very compelling.
Interestingly, our thesis has been bolstered by an unlikely source: the largest direct investors in hedge funds. Anecdotally, those funds command much lower fees than the other 99% of investors. When an investor can offer $1 billion tickets with multi-year lockups, 2/20 isn’t part of the conversation. That fee reduction, in turn, appears to drive outperformance. Our position is that for the other 99%, especially those concerned about liquidity and fees, pre-fee replication is perhaps the most compelling solution.
Q: As I understand it, there are various forms of replication. In the press recently, some of those strategies have been called into question—and I believe you have been quoted on this. Can you describe how this debate has unfolded?
Andrew: The debate was whether it was better to replicate hedge fund portfolios from the top-down or bottom-up. To keep the terms straight, top-down means you try to figure out how hedge funds are positioned across major factors: not just value vs. growth, but also things like currencies, rates, etc. The bottom-up approach often called alternative risk premia, entails building trading strategies around things hedge funds do, like merger arbitrage and currency carry, and packaging them in portfolios.
Five years ago, allocators unquestionably favored alternative risk premia. The products looked amazing on paper and were backed by some of the most prominent quant firms. Going back to the discussion of “alpha,” these guys argued that hedge fund alpha really came from a few strategies hedge funds discovered a decade or two ago and that quants could replicate them today with lower fees and daily liquidity.
We closely examined the products as far back as 2014 and reached a different conclusion. Hedge fund alpha, we concluded, was far more dynamic. While a risk premia proponent might buy value and short growth, from our perch, it was apparent that most hedge funds were on the other side of the trade. Plus, when we experimented with building our own products, we found that small changes in assumptions would lead to very different outcomes, which suggested that these weren’t easily “harvestable” risk premia, but rather risky single-manager quant macro products. Finally, the backtested numbers clearly were unrealistic, but it wasn’t clear how much lower they would be.
Several years ago, our concerns largely fell on deaf ears. Today, though, the alternative risk premia space is widely viewed as a failed experiment. Actual returns across the space have been negative, and some high profile funds have suffered 30% to 40% drawdowns—the statistical equivalent of back-to-back-to-back 100-year floods.
Meanwhile, top-down replication strategies have performed exceptionally well: Three of the top-performing multistrategy funds in the Kepler database follow this approach. It’s not for everybody, but if an allocator wants a low-cost, daily liquid, one-stop hedge fund solution, it works very, very well.
Q: As you mentioned, the UCITS hedge space has had a few high-profile cases where investors couldn’t get their money back. This has not been an issue with the Fund, but can you talk about your decision-making and the broader landscape?
Andrew: We know that asset-liability mismatches in hedge funds are dangerous. 2008 kicked off a decade-long decimation of the fund of hedge funds industry, due in part to the gating and suspension of investors. In 2007, it wasn’t hard to see that funds of funds—which offered monthly liquidity while investing in hedge funds with five-year lockups—were courting disaster.
Five years ago, this seemed like ancient history, and few allocators in the UCITS space were focused on this risk. Perhaps because we lived through the funds of hedge funds debacle, we never took market liquidity for granted. When your anchor investor wants a share class with T+1 settlement, it’s prudent to build a portfolio that is equally liquid. Consequently, the Fund only invests in highly liquid futures contracts (and two capped positions in credit ETFs). The vast majority of the balance sheet is invested by SEI’s team in liquid, short-term, fixed income instruments. By design, our portfolio liquidity can even improve during the most unstable market conditions.
Today, asset-liability mismatches are recognized as a serious risk in the UCITS hedge fund world. In a zero-interest-rate environment, there is a great temptation to invest in higher-yielding, but less liquid credit instruments. In calm markets, this AB IS helps returns. The problem crops up in difficult markets, especially when a fund is hit by redemptions. This can kick off a downward spiral with suspended redemptions and/or punitive swing pricing.
The tricky part is figuring out where the next bomb will go off. The first quarter of 2020 was a shot across the bow when the credit markets froze, but the tsunami-like injection of Fed liquidity in late March staved off a serious crisis. In any event, allocators today are much more sensitive to this risk, and we think it’s a competitive advantage of the fund.
Q: Given the criticism of hedge funds overall, does this call into question the whole concept of replicating the space? How do you respond to that?
Andrew: It’s a great question and, as you know, we have written a lot about changes in the industry— some of which definitely have been negative.
That said, I’m more optimistic about the space than I have been in years. The reason is that 2020 looks a lot more like 2000 than in 2010. So let me see if I can put this in context.
Over 20 years, hedge funds have outperformed equities with much less risk. You can divide this into two regimes. First, during the 2000s, hedge funds shone. Why? Simply put, they made money during a lost decade for the S&P 500. Starting in 2000, hedge funds found much more compelling opportunities outside a traditional 60/40 portfolio. During 2000-02, they were long small-cap value stocks and short large-cap tech—a factor shift that helped to preserve capital during a brutal bear market. By mid-decade, hedge funds had gravitated into emerging markets stocks and capitalized on the BRIC/commodity boom. 2007 was a banner year, as multi-year bets against subprime mortgages paid off. By contrast, 2008 was a bit of a disappointment: Hedge funds declined more than expected, some suspended redemptions, and the industry overall was tainted by Madoff. Overall, it was a great decade.
The 2010s were the opposite. Simple 60/40 portfolios outperformed pretty much everything else. In most cases, it was a brutal decade overall for active management: Under-loved value stocks suffered historic underperformance, and many strategies were hammered by a market seemingly divorced from fundamentals. During this decade, hedge funds actually got a lot right: They shifted into U.S. equities as far back as 2012 and later embraced future trillion-dollar stocks like Apple and Alphabet. In fact, hedge funds returned roughly the same amount over cash as during the 2000s. It didn’t matter: Given the performance of the S&P 500, alpha (net of fees) was negative.
Today, we see the same kinds of extreme valuation disparities that were present in 2000. In recent quarters, we see hedge funds pivot to areas of the market—value, emerging markets, small and mid-cap stocks—that have been overlooked for years. Further, macro trades—long the U.S. dollar and long rates— that favored passive portfolios have reversed. With investors facing a decade of muted, at best, returns from traditional 60/40 portfolios, hedge funds have the potential to deliver meaningful alpha.
To learn about the SEI Liquid Alternative Fund and the fund's recent outperformance, read SEI's Liquid Alternative Fund - 2020 November Update. To find out more, reach out to Georgina Minta for further information at firstname.lastname@example.org.
Former Global Banking, Sales and Relationship Manager, EMEA
Portfolio Manager, Dynamic Beta Investments
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