|With financial markets becoming increasingly more volatile and correlated, investors have found the pursuit of positive returns and capital preservation difficult and are asking the question “Where do I invest in 2008? What sort of investment vehicle can profit from downside and upside market volatility and still provide an investor with liquidity, diversification and accurate pricing?|
”The answer year-to-date has been (1) the Global Macro hedge fund strategy (+6.2% through end of February 2008 as measured by the HFRI Macro index) — a strategy that seeks positive returns trading within global financial markets using a multitude of asset classes and financial instruments which includes both long and short directional exposure to stock market indices, currencies, commodities and bond markets; and (2) investments in commodities (+11.23% through the end of February 2008 as measured by the Goldman Sachs Commodity index).
Both of these sectors are arguably best accessed via hedge funds, which have attracted the top investment talent globally over the past several years and have been the natural choice for investors seeking to generate absolute returns from long and short positions rather than long-only passive investing. Historically, hedge funds have been well-equipped to deliver superior risk-adjusted returns and offer a low correlation to more traditional types of investment. However, the huge explosion in the numbers of hedge funds over the last few years has meant investors can sometimes become overwhelmed when trying to navigate the sheer number of choices of trading strategies and funds that comprise the hedge fund industry.
Given the complexity of many hedge fund trading strategies it is no surprise that funds of hedge funds (FOHF) offer a way to invest into this asset class. These specialist money managers offer a perfect vehicle: investment into several actively managed hedge funds in a single portfolio. However, most funds of hedge funds lack a focused strategy and in fact have become more over-weighted towards equities, thus depriving the investor of portfolio diversification when it is most needed.
Data going back to 1992 has shown that the rolling 36-month correlation between the MSCI Europe, Africa and Far East index and the HFRI Fund of Funds index had risen from near zero in 1992 to over 80% by December 2007. This highlights weaknesses in both the style and the bias of many funds of funds. Put simply, many fund of funds managers have increasingly focused on investing in equity trading strategies and therefore returns may be lower in the future given the forecasted slowdown in world growth.
This is a very strong argument for a sector-specific fund of hedge funds when considering this type of investment. Investors should be diversifying away from equities and into hedge fund management styles that have performed best when equities are in a bear market phase. Additionally, they should look for a fund of funds that targets performance over size of assets under management, where the fund of funds has a high level of expertise in their chosen area of investment and can identify the top hedge fund managers and gain access to those hedge funds. For example, the most highly regarded global macro hedge fund managers have long track records (+20 years) and have demonstrated profiting from the 1987 stock market crash, the 1990 Kuwaiti oil Gulf crisis, the 1997 Asian emerging market crisis, the 2002 global stock market correction and, of course, and the volatility demonstrated in 2008 thus far.
The problem is that managers who have successfully realized positive returns in the above environments are often closed to new investment and/or have large minimum investments (often $10M plus). A superior fund of funds can source, perform qualitative and quantitative due diligence, and negotiate capacity into these top hedge funds. It will also pool client assets together so that investors may invest in several of these top single manager hedge funds — thereby mitigating single manager investment risk at a much lower minimum investment amount for the individual investor.
Global Macro Fund of Funds
Global macro hedge fund managers are typically known to utilize a top-down, thematic investment approach and pursue directional trading strategies in the world’s financial markets utilizing stocks, bonds, interest rates, currencies and commodities.
In practice, what this means is that the hedge fund manager does not restrict himself to a single market or asset class but trades on an opportunistic basis across many different markets. Successful macro fund managers apply their specialist econometric understanding of the world and allocate risk within this framework. This means that they will be looking for markets to be long or short without having to favor one style or market over another. The upshot of this is that macro funds have been proven to capture both the upside of any equity market rally, but more importantly have shown an excellent history of returns when equities have fallen out favor.
An astute reader might now ask why all hedge funds of funds are not invested in macro strategies?
The answer lies in the fact that most hedge fund of funds managers are not equipped to fully understand macro strategy. They have been wary of macro hedge funds because they are difficult to pigeonhole as equity, fixed income or commodity funds. But a fund of hedge funds that specializes in investing in macro funds can offer an excellent opportunity to gain some exposure to this non-correlated type of hedge fund trading strategy, even if the manager has a proven long-term track record and is closed to new investment.
Commodity Fund of Funds
Commodity hedge fund managers typically utilize a fundamental investment approach that combines both macro economic research and traditional supply/demand analysis to construct directional, commodity trades within energy, metal and agricultural commodity futures and option markets.
As a result of falling global supplies and increased global demand, over the past five years many of the commodity markets, from fuel and energy to agricultural commodities and precious metals have seen an incredible rally. Irrespective of the present state of the equity markets, the rally in commodities will likely continue as demand from emerging economies such as China and India seek to:
1. Improve their diets and standard of living (agricultural commodities: meats, coffee, sugar, cocoa, eggs; as well as energy: crude oil, natural gas, etc).
2. Improve their infrastructure by building new homes, railroads, airports and even cities (base and precious metals). The above will likely replace any fall-off in demand from developed nations.
In addition, commodities have traditionally acted as an excellent hedge against inflation. Commodities will therefore continue to benefit as an asset class as central banks universally relax their focus on fighting inflation as they cut interest rates to promote growth and financial stability.
Finally, the commodity markets are themselves very distinct in nature from the equity markets. They can be constrained by factors such as the supply of land on which to grow crops or the rate of discovery of new mineral deposits, they may be influenced by weather or the cost and availability of transportation. All of these factors add up to make the commodity markets quite independent of equities and an excellent asset class for portfolio diversification. However, most investors are wary of investing directly in commodities, a long-only index or even a single commodity hedge fund manager. Again, for long/short commodity exposure to the top commodity trading talent a fund of hedge funds pool focusing on the commodity sector clearly makes the most sense.