Think portfolio - not returns

Selling hedge funds to clients can often be a challenging process. The newness and unfamiliarity of hedge funds can be off-putting, as can their reputation for lack of transparency and perceived degree of risk.

A contrary problem can arise where clients want to invest on the basis of advertised hedge fund returns in isolation from broader portfolio considerations.

These days, however, investors are being wisely cautioned to ‘think portfolio’ rather than chase historical returns in isolation.

So what then is the role of a hedge fund in a portfolio and how best to explain its rightful place to clients?

An example to consider is Tower’s newly released Advantage Hedge Fund (AHF).

That’s why it’s often presented as a good idea to combine the low correlation mixture of cash, fixed income, commercial property and shares in a portfolio.

The idea is that these differing asset types do not share the same performance trends (at least not all the time) and therefore their combination will regularise returns and better meet client expectations of stability in risk and reward.

AHF adds a further dimension of low correlation to the total grouping of assets within a diversified portfolio.

As an ‘absolute return fund’, the product is aimed at making profits for investors regardless of the return performance of bonds and shares. Versus fixed income, for example, the fund has zero correlation with New Zealand and international bonds. That zero has utility when bond values stand to fall versus rising short-term interest rates ahead.

Against New Zealand equities, AHF’s correlation is a modest 0.3, while when compared with international equities correlation works out at 0.4 where the equities are unhedged versus the $NZ and a still acceptable 0.5 where they are.

Considering what clients have experienced with international equities over the past two or so years, the likes of AHF make a suitable – even desirable – companion investment.

How a hedge fund can be used to reduce risk in a portfolio
This risk versus return graph shows where the Advantage Hedge Fund sits historically in relation to other major asset classes – on par with New Zealand bonds for volatility and global equities for return.

Results from historical underlying fund data show that AHF has risk characteristics similar to the New Zealand Government Stock Index, but a return profile akin to the MSCI World Index expressed in $NZ.

For example, over a period of six years, component funds of AHF have had positive return months 85% of the time versus 86% for the Salomon Brothers Global Bond Index hedged to the $NZ.

This ‘bond-like risk with equity-like return’ is no mean feat and is achieved in part by the high degree of internal diversity within AHF.

As a multi-manager, multi-style ‘fund of funds’ hedge product, AHF reduces risks of exposure to bad managers or upsets in the derivatives markets by investing across up to 25 different hedge fund managers chosen by the experienced team of David Zobel, head of Sydney-based Deutsche Bank Absolute Return Strategies. Zobel’s team confines manager styles in AHF to lower risk/lower return relative value, event-driven, and long-short equity.

Currency hedging
The $NZ is expected to rise as our interest rates go up and many clients will be nervous about potential currency exchange losses on their overseas investments. It is worth noting that AHF is itself hedged 100% against the $NZ. This additional overlay of currency hedging should assist the fund to contribute to containing losses in portfolios with substantial overseas exposure.