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Hedge Funds: Finding Opportunities in a Beleaguered Industry

When choosing hedge funds in which to invest, it pays to seek out strategies that capture the strongest parts of the current market.

Judging by some recent headlines, hedge funds must be a dying industry. When an institution decides to terminate its hedge fund program, or when hedge funds broadly underperform equities, the headlines are bold and no doubt generate more clicks. When the industry finished 2015 with a record level of $2.9 trillion in assets, however, that news was in smaller headlines.

We believe that despite the dire news coverage, hedge funds continue to serve as a low-correlated and diversifying return stream for a portfolio, delivering the benefits of active management — alpha — rather than market beta. In efficient frontier parlance, hedge funds have the ability to move your overall portfolio up, left or both.

At 50 South Capital Advisors, our strategy has always been to focus on small to midsize managers with unique sources of return. We recognize that market beta is a commodity that can be added to a portfolio for little cost and is not worth the expense of hedge fund fees. To meet our investors’ expectations, we must allocate capital dynamically, which does not mean we are market timers. Rather, we are opportunity timers, guided by our macro views and moving capital into strategies we feel have the best opportunity set while deemphasizing those facing headwinds. Here are our strategies, going into the second half of 2016:

Relative value. The low-interest-rate, low-dispersion environment of the past few years has been a massive headwind to relative value strategies. But with the Federal Reserve poised to resume its rate hike plan, we believe those headwinds are abating. Our view is that higher market volatility is here to stay, and that should benefit relative value. We see the best opportunities in higher-volatility, diversified, quantitative-market-neutral funds that trade a broad range of asset classes and geographies. These quantitative funds have the ability to move quickly to take advantage of short-term dislocations.

Event-driven. We believe that the event environment is shifting. The post-2008 financial marketplace, awash in liquidity, has been a good one for equity-focused event strategies. We feel that we are in the later stages of the equity opportunity set. The time has come to shift capital to managers that are asset-class-agnostic or credit-focused. Managers with smaller asset bases that can be nimble or newer managers without cumbersome legacy positions are the most attractive to us.

Long-short equity. With equity markets fully valued and increased volatility here to stay, we believe that generating returns through market beta will be ever more challenging. As a result, alpha generation will drive performance over beta, which places a premium on lower-net-exposure, fundamentally biased managers that can demonstrate alpha generation on both the long and short sides of their portfolios.

Global macro. The central bank divergence trade opportunity has faded. Gaining an edge in developed-markets central bank policy has been made all the more difficult by the unpredictable negative market reactions that we have seen recently in Europe and Japan. We prefer managers that have chosen to avoid central bank trades, those that focus on structuring trades through options and those that skew toward emerging markets. Macro is a divergent strategy that has strong portfolio utility. The challenge is to find the best macro performers that can generate reasonable returns and stay in the game while their larger theses play out.

No doubt some hedge funds are under pressure. Many have closed due to redemptions driven by performance issues, and fees are continuously under scrutiny by institutional investors. This situation is good. Hedge funds are a meritocracy. Those that do not meet their investors’ expectations are quickly put out of business. Hedge fund fees attract some of the best talent in the investing world, but they also attract mediocre talent looking to cash in. Separating the talent from the herd is difficult work, but the reward is worth the time and effort.

A well-constructed portfolio of quality hedge funds that dynamically allocates capital to select opportunities can shift the efficient frontier of the overall portfolio either up, to the left or both, and those should be the criteria for any investment — irrespective of the headlines.

Tristan Thomas is director of portfolio strategy, and John Frede is director of hedge fund research; both at 50 South Capital Advisors, the alternative-investment subsidiary of Northern Trust Corp. in Chicago.

See Northern Trust’s disclaimer.

Get more on alternatives and hedge funds.

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