Boosting beta returns by diversifying risk exposure

The truth universally acknowledged, when it comes to hedge funds, is that they boost a portfolio’s alpha, or risk-adjusted returns. But it is equally true, if less well known, that using alternatives can be a way of optimising beta – or diversifying exposure to risk. This is the idea behind using hedge funds as equity or bond diversifiers.

“When you buy a hedge fund, you buy some alpha, but you also buy exposure to some specific risks,” explains Alain Dubois, chairman of Lyxor Asset Management. “You have exposure to the market but also to specific betas such as credit spread, volatility and correlation.” The point, he says, is to diversify these exposures.

It is all too easy just to group hedge funds together, as providing returns uncorrelated to equities or bonds. But in fact the five main strategies – equity market neutral, convertible arbitrage, long/short equity, CTA (commodity trading adviser) global and event driven – have a complex set of correlations among themselves, and against the main bond and equity indices. These are shown in table one.

This means that the thinking investor can use alternatives to optimise reduction of portfolio risk, as well as gain additional alpha. Appropriate strategies can be constructed to provide the optimal exposure diversification for the various combinations of equity and bonds in a portfolio.

There is more to this process than to straightforward asset allocation between the mainstream asset classes, or to diversifying by sector or geography. The aim is to identify a combination of strategies with the most contrasted risk profile compared to those of the traditional assets held by an investor – a process which involves not just reduction of portfolio volatility but also of extreme bond or equity portfolio risks.

Too often, the mix of conflicting betas in a standard multi-strategy fund will not optimise diversification, and so will fail to reduce risk optimally. Far more effectively, benchmarks for equity and bond diversifiers can be established using mathematical techniques.

When it comes to bond diversification, the best strategies are:

• Convertible arbitrage
• Equity market neutral
• Event-driven
• Long/short equity

For equity diversification, the best strategies are:

• Convertible arbitrage
• CTA Global
• Equity market neutral

But how exactly are these strategies to be combined, and the benchmarks to be drawn-up?

All about indices

Invest in hedge funds, and the chances are that it will be through a hedge fund of funds. This is a way of cutting the dangers of putting all of an investor’s eggs into one unregulated basket, as well as allowing the experts (the multi-managers) to do the fund selection.

But it can also be a way – often under considered – of utilising a manager’s potential to combine styles. Hitherto, this has not been done so well as it might. Academic studies have suggested that alternative funds perform inconsistently and that fund of fund managers have been ineffective in combining styles and funds to create regular outperformance (see table three).

Enter hedge fund indices – a way for investors to calculate the “normal” returns associated with the different strategies. The idea is that these indices are stable in terms of beta and, thanks to extensive research, representative of the returns and risks associated with the five main alternative investment strategies - a combination which renders them perfect for asset allocation between strategies over the long term.

Rather than focus on past performance (which is, as we have seen, potentially unsteady), a good index will aim to guarantee investors a normal return associated with the real risks of the relevant strategy.

So how is such an index to be developed? In two stages. Firstly, by picking funds based on principal component analysis (using mathematical techniques to reduce a complex system of a correlations to a smaller, more manageable, number of dimensions). Secondly by allocating funds by an optimisation method, which essentially replicates the principle component for each strategy.

Asset allocation

Given the indices, how should asset allocation proceed? What is the best way to combine them to get the appropriate diversification? It depends, as Mr Dubois points out, on the investor’s overall asset allocation. For a portfolio of, say, 70 per cent in bonds and 30 per cent in shares, there will be an optimal combination of the five strategy indices to diversify risk; for an investor with 50-50 in each, the combination will be different.

A shrewd inter-strategy asset allocation process will be based on two core ideas. Firstly, that it is hard to estimate precisely the future returns of financial assets. One way around this is to focus on minimising risk, rather than optimising the risk-return profile, thereby avoiding the problem of inaccurate estimates.

Secondly, given that hedge funds do not follow a normal distribution, the risk measure used has to be more general than just volatility – it has also to accommodate extreme risks.

Asset allocation, in other words, should be determined by minimising a value at risk indicator which takes into account the non-normal distribution of strategy returns, by including extreme risk factors skewness and excess kurtosis.

However, conveniently and mathematically interestingly, there is a short cut to working out the correct combination for every single portfolio. It turns out, according to Mr Dubois, that the optimal proportion, as a combination of the equity diversifier benchmark and the bond diversifier benchmark (that is, the strategy mix suited to an all-equity portfolio and that for an all-bonds portfolio), will be roughly equivalent to the split of the overall portfolio between equities and bonds.

Avoiding the pitfalls

Using hedge funds has, traditionally, carried the problem of operational risk management. Levels of hedge fund regulation are low, and the industry remains immature with respect to certain procedures: calculating price and net asset value, client reporting, controlling compliance with investment rules. It has, moreover, an immature risk management infrastructure and low liquidity levels.

The result? Each year, many hedge funds will incur heavy losses, or vanish altogether, and for reasons entirely unconnected with their financial management. According to research from Edhec and Capco, some 41 per cent of hedge fund failures are down to misrepresentation; 30 per cent are due to fraud or misappropriation of funds. Inadequate technology or processes accounts for 6 per cent of failures, and trading outside the mandate for 14 per cent. No wonder investors are wary.

The way round this is to create a fund platform, combining a number of products from a number of providers, with an infrastructure specifically designed to control the five main operational risk factors:

• Compliance
• Valuation
• Reporting
• Risk management
• Reconciliation

Essentially, operations carried out by fund managers should be entirely transparent, and the overall platform should have effective control of risk.

More specifically, an effective infrastructure would involve a four-part risk-management process. Firstly, managers (selected only after a strict process of due diligence), should be given a mandate which clearly defines their investment universe and risk limits. Secondly, fund managers should be expected to replicate their fund’s asset allocation in the overall platform.

On top of this, risk control and weekly net asset value calculations should be carried out, independent of the fund managers. Finally, the overall platform should retain the option of sacking a fund manager at any point, especially one who fails to comply with the investment rules, or has unexplained variations in performance.