It is an opportune time for asset owners to explore hedge fund strategies, given the low expected returns from traditional assets, he pointed out. In addition, “investors are looking for diversification from equity and bond beta, and that is where hedge funds can add value when it matters.” But alpha is not unlimited and given that institutional portfolios have specific risk-reward targets, it can be beneficial to tailor a hedge fund portfolio specifically to an asset owner’s unique needs, Foehrenbach said. “Customized solutions, which tap into different alpha signals or hedge fund strategies across asset classes, are a powerful tool that utilizes the extensive analytics that are at our disposal.”
WHAT INSTITUTIONAL INVESTORS ARE SAYING
Diversification is top of mind for many asset owners today. “We spend a lot of time analyzing clients’ portfolios, and the number one risk that we identify is equity risk, or growth risk, which can be defined as an economic rather than a market risk,” he said. “If the economy stops growing, that has an impact on the value of our clients’ portfolios.”
The traditional pursuit of the 60/40 stock/bond portfolio has recently not delivered the diversification as expected in the past, he noted. Monetary and fiscal stimulus post-COVID brought persistent inflation, leading the central banks to raise interest rates, which in turn has impacted both stocks and bonds. Investors, therefore, need what Foehrenbach terms “holistic diversification.”
A second closely related investor objective is liquidity. “Diversification is most valuable when it comes with good liquidity. Some argue that assets that aren’t marked to market also diversify, but they’re not that helpful when you can’t utilize them, that is, you can’t monetize the diversification benefit,” he said. Liquidity is needed to meet cash flow needs or allow for portfolio reallocation — immensely valuable benefits, particularly during a liquidity crisis, Foehrenbach explained.
POTENTIAL HEDGE FUND SOLUTIONS
Trend following is an example of a strategy that provides holistic diversification: “Trend following is an essential building block of a diversifying portfolio because it has a defensive return profile that picks up on trends, including downtrends in asset prices,” Foehrenbach said. “It is a diversifier because it is not reliant on equity risk premiums, for example.”
As a quantitative, algorithm-driven program, trend following “doesn’t care” whether commodities, interest rates, bonds, equities or currencies are moving down or up, he said. “When does it not work? Sharp market reversals are not ideal.” By combining the strategy with others, such as discretionary, other quantitative, macro or convex strategies that will react to the market reversal, investors can meet overall portfolio diversification goals, he said.
Opportunities in credit
For investors seeking diversification and return, convertible arbitrage — which typically involves going long a convertible bond and short in its underlying stock — could provide a defensive strategy in some markets. The portfolio manager “typically hedges out the equity risk but is inherently long volatility and, in some cases, can be long credit risk,” which is quite interesting in the current environment, Foehrenbach said.
Within the credit theme, investors can also consider opportunities in idiosyncratic strategies. Given the catalyst of higher interest rates, somewhat weaker covenants overall and tighter bank-lending standards, Foehrenbach has the view that corporate bond defaults will increase. Europe, in particular, doesn’t have as robust bankruptcy laws as in the U.S., and its balance sheet restructurings are fairly straightforward, but it has very country-specific idiosyncracies, he said. “If you can navigate these regional bankruptcy laws, that basically means there’s opportunity in less capital and potentially more alpha.”
Merger arbitrage — arbitraging the mispricing of two companies that are merging — has also seen some recent developments that suggest regulatory risks are abating to some extent. “That would mean that managers may be able to capitalize on wide spreads without incurring the risk of deal breaks,” Foehrenbach said.
The future is moving toward customization
Man Solutions’ approach allows the firm to utilize its multiple hedge fund strategies or “alpha engines” within or outside the firm and customize them to meet very specific client portfolio needs. “The ability to customize, by combining different strategies which have orthogonal payoffs, is powerful,” he said.
This bespoke approach helps the firm to build a close partnership with clients and leads to deeper conversations on evolving issues such as liquidity and volatility. “It’s important to be very precise about the portfolio objective or problem, and then you can be very specific in how you address it.” He added that “you can then also pursue opportunistic or tactical investments that present themselves.”
KEY CONSIDERATIONS FOR INSTITUTIONAL INVESTORS
Liquidity has become more important than ever, particularly as the increase in institutional allocations to private assets has created a higher liquidity demand on the rest of the portfolio, Foehrenbach pointed out. Since the great financial crisis, the rigid regulatory framework imposed onto banks and other market participants has led to pro-cyclical liquidity — as observed during the COVID sell-off when all market participants sought liquidity at the same time, including banks. Treasuries, the most liquid market, declined in price as well, he noted.
This recent history is important for understanding trade-offs facing investors in nontraditional assets, given the illiquidity of some alternative strategies. “You cannot harvest a liquidity premium and at the same time solve for that liquidity problem,” Foehrenbach said. “These events put to the forefront for CIOs, ‘How do I generate liquidity when markets go haywire?’” he said. They are more focused on considering ways that their hedge fund portfolio can diversify liquidity risk. Liquid strategies such as trend following or the larger alternative risk premia sector can both generate returns and deliver the liquidity that investors may need during a market dislocation, he said.
Vet the soft factors when selecting a manager
When evaluating a hedge fund manager, institutional investors are used to looking at the hard factors in due diligence, such as risk-adjusted returns, experience and the risk management framework, but “soft factors” are relevant too, Foehrenbach said. Whether it’s a discretionary or systematic manager, “Do they feel comfortable challenging groupthink or specific biases? Do they speak up?” he said. “Diversity is important too. Is everyone from the same background or not? How do they get along with the executive team?”
To get a holistic read on a manager’s abilities, investors should “spend time with the manager, see how they react to challenges.” An experienced asset manager works within an industry network that investors can tap for cross references, and they should talk to the manager’s service providers as well as ex-employees for background. “It’s a more complex mosaic than just looking at the track record” of a manager.
An “AI” toward the future
Machine learning and AI are likely to change hedge fund investing and are highly relevant to the future of the industry, Foehrenbach said. “Number one, it will change the business model of companies that managers invest in, which has impact on their valuations. The second trend is the investment process. What tools can we deploy to become smarter investors? Machine learning and AI will become alpha generators. Thirdly, it has an impact on the operational leverage of the manager. It will make processes more efficient, which opens up resources that can be deployed otherwise.”
Though all the implications of machine learning and AI are not yet fully understood, Man Group is well positioned for any future developments, Foehrenbach said. “Man has a quantitative DNA, and that lends itself to deploying these tools early, aggressively researching them and thinking about how they will change investment processes and companies. This isn’t new for Man as we have had a co-operation with the Oxford Man Institute, which addresses fundamental problems in quantitative finance with a strong focus on machine learning and data driven models.” ■