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The perfect complement to traditional asset classes?

Franklin Templeton’s alternative arm, K2 Advisors, says funds of hedge funds (FoHFs) offer a complementary option alongside traditional fixed income holdings and can provide a liquid alternative exposure for institutional investors.
The perfect complement to traditional asset classes?

AsianInvestor interviews Brooks Ritchey, senior managing director at K2 Advisors, who has been in asset management for over 30 years and helps discuss the key ingredients for constructing a portfolio that many institutional investors may want to consider if uncertain about the outlook for traditional equity and bond markets.

AsianInvestor: Why may FoHFs be an efficient complement to traditional fixed income or equity portfolios?
Brooks Ritchey: The primary asset allocation decision for many investors has been whether to tilt towards bonds or equities, but what if you’re not sure that the returns from either equities or bonds are going to continue to rise?

Investors have recently realised that alpha-driven performance – created by going long certain stocks or bonds and short others – is a viable choice. All of a sudden this has become a competitive source of returns – especially when seeking a complement to government bonds in an environment where one anticipates a period of rising interest rates.

Also, while equities had a very strong year last year,when US stocks rose around 30%, investors may be looking for ‘equities diversifier’ portfolio ideas to help preserve recent gains – what some call ‘equity replacement’ funds of hedge funds. This type of thinking makes sense given the recent recovery in the alpha cycle and the possibility that the equity beta cycle may stall now that we are five years into the global financial crisis recovery.

In the past, many people bought bonds as an equity diversification tactic. But now it’s possible that yields will move higher, and the best move may not be to buy bonds and trim equities, but to trim both equities and bonds while increasing exposure to alpha-driven hedge fund strategies. That’s an allocation rotation theme we think may be prudent and responsible.

What sort of alpha have FoHFs been providing?
Since January 1, 1990, the HFRI Fund Weighted Composite Hedge Fund Index has returned 10.92% on average per annum through February 2014. The average performance contribution from the alpha component (versus the S&P 500 equity index) has averaged 6.37% annualised, net of manager fees. In other words, the returns generated through the selection of which securities to go long versus short has been above 6% on average. Thus, approximately 58% of the annual gains in the HFRI hedge fund of funds benchmark index has been derived from alpha; not market trends.

With many government bond yields trading below 3% and many equity index dividend levels near historical lows, one might consider hedge fund alpha as a competitive performance source while worrying less about equity and bond market moves. The potential for alpha to remain a viable contributor to portfolio returns is compelling. Research we have done indicates that alpha has historically shown a strong relationship with interest rate levels. Higher interest rate periods have been associated with higher alpha.  

How do FoHFs stack up against alternative beta strategies?
In general, FoHFs aim to generate alpha from a larger number of sources (security selection, sector rotation, etcetera) than liquid alternative beta products. Recently however, the liquidity profile has increasingly becoming blurred as active manager hedge fund of funds have become available in daily priced structures such as mutual funds and Ucits vehicles. These daily vehicles, containing fee-efficient active hedge fund holdings, may have the performance edge in a strong alpha cycle environment.

Hedge fund allocations seem to have been rising in recent months. Have this been reflected in demand for funds of hedge funds?
Yes, recently we’ve seen strong interest from Australian, Japanese and North American institutional clients. The demand for daily priced mutual fund FoHF also continues.

So the fees within FoHFs are justified?
Sophisticated clients are focusing more on the fees paid relative to the diversification benefits and performance potential offered by FoHFs and other investment choices. One metric we have seen used is the alpha-to-fee ratio. They are hoping to receive a certain amount of alpha for a certain level of fee and use this alpha-to-fee ratio to compare long only products versus those that are more hedged or alpha-driven.

They also feel the low volatility and less correlated performance profile of FoHFs fits well within their total portfolio plan and that the added value they receive from their FoHF partner’s manager research, operational due diligence, risk and legal teams is worth the fees charged.

To learn more, please get in touch with Franklin Templeton Investments.

Sources: Bloomberg, K2 Advisors

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