The “right” place for alternative strategies in a portfolio

In an environment of zero risk-free rate of return and intense exploitation of anomalies to produce independent market returns, alternative strategies must more than ever be nested within the asset allocation as a whole, rather than considered separately as satellite around a conventional core of portfolio assets.

Hedge funds may have been the winners in the bear market of 2002, but in the crisis of 2008 they were among the biggest losers. Locked in to losses by “gates” and other “side-pockets”, private investors have been disappointed by their performance in the market rally over the past four years. Today aversion to liquid alternative strategies has reached record levels. Even the recovery in performance seen in the hedge fund industry over the past few months has changed nothing.

However, to take advantage of the rebound to cut the allocation to this asset class completely would be inappropriate. Instead, we have decided to adapt our funds of hedge funds to optimise their role in the portfolio.

In essence, the performance of an alternative strategy can be broken down into exposure to systematic factors, commonly called risk premiums, and specific factors, in other words the ability of a manager and team to add value in an asset class regardless of the performance of that asset class. This distinction between betas (dependent on market returns) and alpha (independent market returns) has led some to promote a management approach explicitly recognising these two components.

Under this approach, the portfolio is considered to consist on the one hand of a majority of traditional investments (bonds, equities, securitised real estate, etc.). The investor gains exposure through simple, liquid and cheap instruments: that is, exposure to betas. This exposure is then complemented by more sophisticated and expensive instruments that seek to capture alpha. In practice, and in the context of portfolios that cannot or do not wish to use leverage, this approach has the disadvantage of absorbing a lot of capital, leading to sub-optimal allocation of assets globally.

Our approach is to define our exposure to hedge funds by type of strategy and risk premiums. Specifically, we first exclude strategies where the risk/reward does not offer any advantage over traditional assets. We then combine attractive strategies based on the systematic risk premiums to which they are constantly exposed. Finally, we allocate these subgroups based on their complementarity with traditional asset classes, subject to the same risk factors.

To this end, we completed the restructuring of Pleiad by transforming a broadly diversified portfolio with low volatility to a concentrated portfolio of eight specialised managers in credit and distressed debt. This focus allows us to use Pleiad to diversify our allocation to credit risk in portfolios by optimising the capital allocated to these strategies, focusing on a limited number of managers with a clearly identified competitive advantage and optimising the costs associated with non-traditional investment strategies.

In an environment of zero risk-free rate of return and intense exploitation of anomalies to produce independent market returns, alternative strategies must more than ever be nested within the asset allocation as a whole, rather than considered separately as satellite around a conventional core of portfolio assets.

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