With equities near all-time highs and concerns about rising interest rates intensifying, many investors are realizing that they may need to diversify their portfolios, and they may need to do it now.

“Hedge funds have broad investment mandates which provide them the flexibility to determine where opportunities exist and when to allocate to individual risks across multiple asset classes and geographies,” said Jordan Drachman, director and head of the Credit Suisse Alternative Beta Strategies group. “Unlike traditional long-only managers, hedge funds have the ability to use a variety of investment strategies ranging from short selling to leverage which can help them seek to achieve an alternative source of return to traditional investments.”

Hedge funds in particular have tended to be only moderately correlated to the betas of traditional equity markets. Historically, average capture for hedge funds has tended to rise during bull markets while downside correlation has decreased during bear markets resulting in asymmetric payouts.

And hedge funds are not just an alternative to equities; they are also relatively uncorrelated to bonds, which have taken on a more significant weight in many portfolios, causing many to fear the potential impact when interest rates rise.

“Our research shows that a portfolio including hedge funds would have outperformed a traditional 60/40 allocation on an absolute and risk-adjusted basis, and would lower the volatility of the overall portfolio,” Drachman said. “The diversification potential of alternatives continues to be the key driver of demand. Recently, investors have seen uncharacteristic correlations among asset classes and understand that it’s important to focus on diversification now, before the next big market move.”

Manager access and selection are the keys to success when investing in alternatives. Most investors do not have the required access or skills/resources to construct an effective alternatives programs made up of a dozen or more funds.
Therefore, historically, hedge fund of funds have stepped in to perform these critical functions for investors.

“Unfortunately, the extra layer fees charged by fund of funds on top of an already rich 2/20 fee structure of the underlying managers, coupled with the fact the average fund of funds has tended to underperform the average hedge fund (which itself is poor) has meant that investors have grown very wary of fund of fund vehicles and this has fueled demand for new alternatives solutions,” said Maz Jadallah, CEO of AlphaClone and manager of the ALFA ETF.

Alternatives (hedge funds, private equity, managed futures) often have a lot more flexibility around security selection (public/private), investment direction (long/short) and the use of leverage and hedging than traditional public equity strategies.

Therefore, alternatives give investors access to potentially different sources of “alpha” (performance) than traditional equity strategies.

“Those sources of alpha can also be non-correlated to public markets and to each other which give the investor additional benefits when including alternatives in their portfolio,” said Jadallah. “Hence investor demand for alternatives.”

In the hedge fund world there are basically four approaches to “liquid alternatives” (mutual funds, ETFs, SMAs): beta factor replication, fund of funds in 40 act form, direct single manager access in 40 act form, and manager holdings replication (AlphaClone’s approach).

Manager holdings replication offers the “potential for top quartile hedge fund performance (going for alpha not beta), liquidity, transparency, low fees, no manager direct risk, no manager switching costs, customizable hedging to match volatility requirements of investor, and a rules based approach to avoid behavioral pitfalls,” Jadallah said.

The criticisms of this approach are that it uses public data sources, which disclose long positions only, is delayed (45 days after end of quarter), does not include non-public or non-U.S.-exchange traded holdings, and may exclude positions for which a manager has requested confidentiality.

Many of these criticisms are unfounded, Jadallah said.

“A manager’s outperformance is largely due to their long positions not their short positions,” he said. “Otherwise, performance for the manager’s long-only clone would not come close to approximating the manager’s actual performance.”