Why hedge fund investing could raise instos' risks

Asset owners looking to diversify portfolio risk with hedge funds may see limited gains or even losses as the Covid-19-induced financial crisis renders fundamentals irrelevant.
Why hedge fund investing could raise instos' risks

The mini selloff of US stocks on June 12 revealed to investors and fund managers that the worst of the global pandemic is not yet over. A recent spike in coronavirus cases in the country has revived fears over whether the current lifting of lockdown measures is premature.

During turbulent times like this, market fundamentals become irrelevant. That is causing some hedge funds to struggle to stand out. Long-only fund managers argue asset owners should be cautious, as too much hedge fund exposure may leave investors seeking diversification ironically at more risk of market vagaries.  

Overall, hedge fund strategies, including those relying on fundamental pricing inefficiencies between assets to generate returns, saw a loss of 5.36% year-to-date as of the end of May, according to eVestment.

“Liquid alts (alternative asset investment) strategies that try to take advantage of any mispricing between fundamentals are idiosyncratic because during times when fundamentals don’t matter such strategies are likely to struggle,” Nick Samouilhan, a Singapore-based multi-asset strategist at Wellington Management told AsianInvestor.

Nick Samouilhan
Nick Samouilhan

Samouilhan’s comments came as a global survey published on June 16 by Natixis indicated that over half of the financial advisors and experts saw the initial volatility caused by the pandemic as driven more by sentiment than by fundamentals.

“As markets decline you have a period where the pricing of the market isn’t about fundamentals, it becomes about flows,” he said.

Moreover, fundamentals are likely to remain challenged, and hedge funds are “fighting a losing battle” as central banks are poised to inject more market liquidity into the market, said Duncan Moir, a senior investment manager at Aberdeen Standard Investments.

That some hedge fund strategies are highly correlated with other asset classes and the rest of the portfolios should also merit more caution by investors looking to diversify their risks exposure via these assets.

“Say you have an equity portfolio, and you are trying to diversify some of that with liquid alternatives, one thing about which you should be very careful is going into big global macro funds when they have lots of equity beta on,” said Samouilhan.

Equally, credit-focused hedge funds, for example, will also be impacted by the rise in defaults in the debt market as the outbreak has put companies in sectors, including airlines and hospitality in distress. Moir said credit managers would need to be “selective” to avoid any pandemic-related defaults.

Hedge funds utilising macro strategy and credit strategy declined 2.05% and 6.16% year-to-date as of May’s end, according to the latest figures from eVestment.


But with more countries easing lockdown measurers, such as Singapore, which has exited a two-month circuit breaker period, Samouilhan said fundamentals would eventually be applicable again, and that investors and managers will learn a lot more over the next quarter about the pace at which the world is recovering from the crisis.

This will, ultimately, benefit hedge funds that generate returns through fundamentals.

“If you can take a longer-term view when fundamentals start to matter again, and they will, then buying good companies, good securities where the fundamentals are strong, will lead to outperformance,” he said.

Investors should also analyse their investments and untangle from where their hedge funds are getting the returns, and whether their managers can turn such opportunities into returns themselves, he added. The return drivers could lie in primarily the skillsets of the managers or access to illiquidity premia, for example.

Having said that, Samouilhan said he doesn’t see hedge funds being a large part of Asian investors’ portfolios, as idiosyncratic risks will rise with more allocations to these assets, making them harder to model.

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