RIAs Count on Hedge Funds for More Than Returns

For registered investment advisers seeking funds that deliver diversification with low volatility, choosing a benchmark is just the first step.

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By billing themselves as deliverers of alpha, hedge funds have invited criticism from the media and other quarters. Such promises to beat the market help feed the stereotype of hedge funds as hit-or-miss investments that produce volatile, outsize returns. Have a good year, and investors will be thrilled; catch a bad year, and losses will be heavy.

For sophisticated investors such as registered investment advisers, though, hedge funds play a different role in client portfolios. These players seek to identify funds with consistently positive risk-adjusted returns that add diversification. Steven Karsh, principal and director with Innovest Portfolio Solutions, a $12.8 billion, Denver-based RIA, points to his firm’s experience with a fund of hedge funds that has beaten the S&P 500 index since inception in 1995, with one third of the broad market index’s volatility.

“That’s what you’re trying to get with hedge fund exposure — at least that’s how we place it in portfolios,” Karsh says, adding that Innovest looks for funds whose performance falls somewhere between that of stocks and bonds. “We want bondlike volatility with equitylike returns,” he notes. “And I think in the hedge fund space, you’re trying to make money regardless of whether the market goes up or down.”

To identify funds that match this profile, advisers must move beyond the S&P 500 as a benchmark. Mark Thomas, director of hedge fund research with $41 billion RIA CTC myCFO in Portland, Oregon, says evaluating performance against a passive, long-only index can give a sense of the fund’s incremental impact on a broader portfolio when it comes to alpha, beta and diversification; adding sector or style indexes can improve the analysis.

But many hedge funds are less volatile than traditionally cited performance benchmarks like the S&P 500, Thomas observes, so those benchmarks don’t allow for risk-adjusted performance comparisons. Although performance metrics like the Sharpe ratio can adjust for risk, it’s still helpful to use hedge fund indexes, he says.

Innovest turns to indexes from Chicago-based Hedge Fund Research (HFRI), which cover aggregate and niche fund categories, as more useful yardsticks. Karsh says his firm benchmarks clients’ positions to the appropriate HFRI fund-of-hedge-funds index: Composite, Conservative, Diversified, Market Defensive or Strategic. The analysis starts by matching a fund’s volatility, as measured by its return’s standard deviation for the relevant period, to the HFRI index with corresponding volatility. It’s not just a numbers comparison, Karsh notes: The firm also examines the fund’s and the index’s underlying strategies to ensure that the benchmark is the right fit.

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The investment committee at $10 billion Plante Moran Financial Advisors in Southfield, Michigan, also uses the HFRI indexes as a starting point, according to Mark Dixon, wealth management partner and head of the firm’s institutional investment consulting practice. But Dixon adds that it’s important to recognize that a fund’s performance is specific to the manager, strategy and style. He gives an example of two long-short funds. The first exhibits a beta close to 1.0, which matches the S&P 500, whereas the second fund’s beta is much lower. “Those managers, if that’s their styles, would be expected to perform much differently depending on the market environment,” Dixon says.

It’s vital to evaluate funds over long periods, because performance can vary considerably in the short term, Innovest’s Karsh maintains. He cites the performance of one unnamed fund that follows a tactical investing style. The fund overweighted credit strategies as the economy emerged from the credit crisis. That approach paid off, and it outpaced the HFRI benchmark for several years. For the past 18 months or so, as a result of its shift toward event-driven strategies, the fund has underperformed, Karsh says.

But Innovest hasn’t pulled out. As Karsh explains, the firm considers multiple performance periods and factors when it evaluates funds. Those factors include rolling three-year performance, return consistency and comparisons with fund peers and indexes. “You might have a really bad quarter, and it might skew the three- and five-year numbers,” Karsh says. “But if you actually dig down into their numbers, they might have done really well on other periods.”

Hedge fund performance is just one metric, though. Peter Hecht, senior investment strategist with $5.4 billion alternative-investment manager Evanston Capital Management in Evanston, Illinois, stresses the need to evaluate funds and other investments from a portfolio perspective. “You need to look at how this particular manager fits in with the rest of the portfolio you’re building,” he says, “and make sure it offers a return that is appealing, once you take into consideration and give it credit for the risk and diversification properties it has.”

From a qualitative perspective, it’s also important to analyze fund performance for style drift and changes at the firm level, CTC myCFO’s Thomas says. In his experience, extended periods of success or failure can lead portfolio managers to use inappropriate levels of leverage, hedging, concentration or cash in response to greed or fear. Thomas also tracks whether a fund’s management team is sticking with its area of investment expertise and follows its organizational performance, including its ability to retain key employees. “Ultimately, it is important to triangulate across all of these qualitative and quantitative factors to evaluate hedge fund performance,” he says.

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