September 2012 Bermuda Re/insurance
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At the other end of the spectrum are styles that incorporate significant directional bets or that tend to be net long beta over time, including emerging market, equity hedge, and event-driven strategies. Investors who select these styles expect more return enhancement, but with the additional volatility that comes with greater exposure to, and correlation with, market risks.
Total return versus absolute return
One of the key differentiating features of a hedge fund is the degree to which it focuses on total return versus absolute return. Where a strategy lies along this spectrum will significantly influence its behaviour across various market environments. Allocating to both return approaches can help diversify a portfolio of hedge funds by combining strategies likely to do well in bull markets with strategies designed to protect in down markets.
Total-return hedge funds tend to have persistent long exposure to major market risk factors such as beta, leverage, volatility, and momentum, along with more aggressive return objectives and greater return volatility than absolute-return hedge funds. In contrast, the latter often explicitly neutralise systematic exposure to market risk factors and, absent the use of substantial leverage, experience relatively lower return volatility. Many absolute-return strategies focus on risk mitigation and return
Absolute-return strategies for the
fixed income investor While some insurers are exploring alternative strategies that operate
partly or wholly outside the public fixed income markets, there are other paths to achieving positive returns across varied market environments that are centred more squarely in fixed income.
Wellington Management’s Global Total Return approach, for example, is an absolute-return strategy designed to be market-neutral and uncorrelated to traditional market beta and risk assets, with an alpha target of 4 to 6 percent over cash. This team-based approach aims to generate consistent absolute returns through allocations to multiple fixed income strategies, including fundamentally based macro, model- based quantitative, bottom-up credit, and emerging markets. Each of these alpha sources is managed by a specialised portfolio manager or team of portfolio managers, and implemented across the broad global fixed income and currency markets.
By combining independent alpha sources, Global Total Return
portfolios are diversified across investment styles (eg, fundamental versus quantitative), market sectors, investment themes, strategies, and time horizons, which ensures that portfolios are not dependent on any single source to drive returns. The diversification of active portfolio risk leads to more consistent risk-adjusted returns across a wide variety of market environments.
consistency rather than maximisation of return. In some environments, such as bear markets, an investor may prefer lower return targets with fewer and less severe drawdowns.
Total and absolute return: some practical applications Adding long/short equity strategies to a traditional long-only equity
allocation has several potential advantages in a total-return-oriented context; absolute-return approaches can help mitigate the trade-off between volatility reduction and asset growth for retirement plans and other liability-focused investors.
Number of managers: how much diversification is enough? Our research suggests that a hedge fund portfolio can be diversified
with a relatively small number of funds. The portfolio’s mix of styles, and how those styles are internally diversified and cross-correlated, are more relevant than numbers of managers in evaluating portfolio design.
Evaluating a fund-of-funds approach
Funds of hedge funds come in a range of formats, from externally and internally managed to multi-strategy approaches overseen by a single manager. We discuss the pros and cons of these various approaches from an investor’s perspective.
The full white paper can be found at:
www.wellington.com/docs/diversifying_HF.pdf Adele Kohler
Wellington Management.
Conor McCarthy is director of client investment solutions at Wellington Management.
For more information on Wellington Management’s alternative investment approaches and total-/absolute-return strategies, please contact:
US and Bermuda Rich Coffman Tel: 617-951-5311 Email:
RMCoffman@wellington.com
UK and Europe Bob Sharma Tel: 44-20-7126-6068 Email:
BSSharma@wellington.com
This material and/or its contents are current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares or other securities. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients.
Jon Wagenseller Tel: 617-289-3805 Email:
JWagenseller@wellington.com
is director of alternative investment solutions at
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