Commentary: RMS — a better mousetrap to deploy hedge fund strategies

Most asset owners understand the "what" and the "how" of risk-mitigating strategies, or RMS. Yet many still trip over the "why" and the "when." This is because an RMS framework isn't designed to be tactical in nature, even if the name implies allocations are geared for risk-off scenarios. In fact, these are designed to be strategic allocations that adds value over a full market cycle. While this should obviate the timing question altogether, that's not always the case.

Even in a market in which a 60/40 portfolio was down by more than 16% in the first half of 2022 (comprised of the MSCI ACWI and the Bloomberg U.S. Aggregate Bond indexes, respectively), some investors are concerned that a trough in the market seems like the wrong time to mitigate risk. This argument still assumes that traditional fixed-income strategies are providing the same uncorrelated exposures they provided over the past 20-plus years. It seems clear fixed income may no longer provide the same protections; investors could still benefit from additional diversification such as RMS.

Another reservation, one that can be traced back to investors' past disappointment, revolves around the performance of many hedge funds during the global financial crisis and more recent stock market corrections. Subsequent mistrust or skepticism in many cases could be linked to misunderstandings or even warped expectations around how this asset class — oftentimes poorly defined too broadly and imprecisely as "hedge funds" — should perform during periods of stress. Many hedge fund strategies aren't creating a significantly hedged strategy in the first place. These were points, for instance, that each came up during a recent webinar on the topic.

RMS, however, isn't about adding diversification for the sake of "more" diversification; it's about extending the breadth of truly uncorrelated exposures to the benefit of the entire portfolio. Said another way, another type of security (e.g., international versus domestic), another manager, or a different factor isn't going to diversify away from the main driver of many asset classes, economic-growth risk. The ability to rebalance offsetting gains should improve the overall performance in both the near- and long-term. However, RMS isn't only a downside hedge; it incorporates strategies expected to produce positive returns across most market environments, which underscores the point that timing is a non-factor.

A traditional "alternatives" allocation might lump hedge funds into a motley mix of private equity, venture capital, real assets, and private credit. An RMS framework instead creates a strategic, dedicated function-driven exposure that places at least as much emphasis on strategy selection and portfolio construction as it does on manager selection. Compared to other strategic investment classes, RMS tends to be far more dynamic.

RMS programs do this through three primary components, each tailored to protect against different scenarios — quick, high-velocity drawdowns that are more volatile in nature and measured over days or weeks; longer-term drawdowns that occur over months or quarters; as well as periods of growth or even flat markets. Together, each component of an RMS allocation should more precisely leverage the attributes of specific strategies so each is positioned to protect against the different risks they're designed to hedge against or, alternatively, capitalize on opportunities others may be unable, due to structural impediments or behavioral biases.

For investors who are today contending with the denominator effect, an RMS framework can also simplify rebalancing decisions, providing uncorrelated holdings that investors can sell after they have appreciated in value, versus assets that have merely lost less than other allocations and have to be unloaded at inopportune times.

While there may be different flavors of RMS, at Meketa we've classified the different components as first responders, second responders and diversifiers. The first responders category offers the first line of defense against market declines, and utilizes long-volatility strategies and also may include long-duration U.S. treasuries and tail-risk programs, all designed to zig when the market zags. The second responders, alternatively, benefit during a more protracted drawdown and can include trend-following strategies with a diversified set of look-back periods or more dynamic approaches. Finally, the diversifiers — mostly uncorrelated with the capital markets — may include everything from global macro and equity market-neutral strategies to relative-value and event-driven strategies. In aggregate, the diversifiers are designed to be agnostic to moves in equities, interest rates, credit spreads, commodities and currencies.

As an evergreen strategic asset allocation, the payoffs of an RMS exposure — be it a 10% allocation or multiples of that amount — go beyond positive expected returns and protection against market shocks. Liquidity for rebalancing or liability requirements is not a small consideration during periods of market volatility. This is particularly the case as a larger proportion of assets gravitate to illiquid private markets.

RMS allocations are often customized for each investor. For instance, as part of any implementation, RMS can serve as a stand-alone exposure. It can also be combined with duration beta to complement more traditional liability-driven investment programs or fixed income portfolios. The allocation can even be paired with multi-asset beta exposures to enhance the risk-adjusted returns available through traditional long-only active equity portfolios and total asset allocations.

The outcomes, regardless of how RMS programs are structured, can position investors to participate in the highs of the market but better protect against the lows. Contrasting the benchmarked performance of RMS portfolios against the HFRI Fund-Weighted Composite index may seem like an unfair comparison. There's a growing belief that hedge funds should not even comprise their own asset class — it's akin to saying you participate in athletics versus specifying a distinct sport. But the RMS benchmark, when juxtaposed against the HFRI, shows a stark difference in outcomes, underscoring the benefits of having a strategic purpose-built program.

In what has been an incredibly volatile year, most RMS portfolios continue to perform as expected. Through the first half of 2022, a proxy for RMS stands in positive territory, while the S&P 500, the Bloomberg U.S. Bond Aggregate, and the HFRI FWC indexes experienced significant losses amid the most recent market dislocation.

RMS portfolios have very much entered the mainstream conversation. This is true even among more aggressive investors who are deploying RMS programs to offset potentially higher-risk, return-seeking directional exposures such as public equities, private equity or private credit.

But there's no singular "right way" to incorporate an RMS program into a portfolio.

A common thread, however, is that adopters have eliminated their biases around the role of hedge fund strategies in a diversified portfolio. This helps clear a path for asset owners to fine-tune how RMS programs are deployed in a more sophisticated and effective way. Ultimately, this allows investors to innovate their approach to asset management and benefit from a strategic, evergreen allocation that can thrive across multiple market environments, particularly the most challenging.

Brian Dana and Ryan Lobdell are managing principals and Jason Josephiac is senior vice president at Meketa Investment Group. Messrs. Dana and Josephiac are based in Westwood, Mass., and Mr. Lobdell is based in Portland. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.