Let’s start this blog post with a broad look at hedge funds and then dig into why and how hedge funds are adding alternative investments to their portfolios. First, a hedge fund operates much like an ETF or mutual fund, but is essentially an unregulated common fund, and thus has much more investment choices or flexibility than mutual funds or ETF’s. Unlike traditional funds, hedge fund performance is uncorrelated with general share or bond market trends in general.
Second, the primary definition of “hedge” simply means to cover one position by taking another, symmetrical position. This does not mean that all hedge funds follow no-risk strategies; hedging each position perfectly would prevent the funds from achieving their performance goals or outperforming comparative indices like the S&P.
Third, the hedge fund industry has become highly technical, and its managers are generally very experienced, independent-minded, and often invested in the funds they manage. Hedge fund managers are generally compensated on fund performance – and compensated pretty darn well.
Fourth, because hedge funds base their strategy on a single approach and may make ample use of derivatives, they do not fit traditional mutual fund categories. Hedge funds face little regulatory oversight, although this may be changing. They are popular in the United States and offshore sites and are attractive because they promise investors alpha or index outperformance, theoretically at a lower risk. A hedge fund generally focuses on a single strategy, which is why there are as many types of hedge funds as there are strategies.
Finally, for the most part, hedge funds attract wealthy and well-informed investors, due to their positive performances in both growth and slumping markets. They almost always have minimum investment hurdles in the hundreds of thousands of dollars.
What is an Alternative Asset and Why are They So Attractive to Hedge Funds?
Basically, an alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments include private equity or venture capital, hedge funds themselves, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment and has become very popular as a hedge fund investment. Most alternative investments are unregulated by the SEC and tend to be somewhat illiquid.
To give you an example of the alternative investing trend, BlackRock Inc, the world’s largest asset manager, is pushing more aggressively into private market investments as the firm detailed at an investor presentation in recent months.
Since interest rates were slashed to near-zero across the globe at the start of the Covid-19 pandemic, investors have sought out other sources of yield. BlackRock, in its investor day presentation, said alternative investments – including private equity, real estate, hedge funds, and venture capital – can offer a market-beating edge. Private market investments recorded 18% revenue growth for the company last year, twice the rate of the broader hedge fund industry.
BlackRock, which manages $279 billion in alternative assets, said its portfolio advisory business is moving away from the traditional model of a 60% equity, 40% fixed income breakdown in portfolios in favor of a 50% public equity, 30% bonds, and 20% private markets split.
The firm also outlined the opportunities for growth it sees in China and emerging markets. BlackRock said this has picked up momentum since the early summer when the firm received a license in China for a majority-owned wealth management venture, the country’s fast-growing asset management market.
The average institutional investor including hedge funds, family offices, and endowments typically has up to 30% of their portfolios in investments other than stocks, bonds, and mutual funds. Again, these investments can be in real estate, venture capital, and hedge funds, among other things. Compare this with the average individual investor who is putting 95% of their money into the stock market.
As another example of the alternative investment trend, the chart below itemizes the investment allocations of the Yale Endowment Fund. This fund is an interesting case study because many decades ago, Yale diverted money from just stocks and bonds into more alternative assets like hedge funds, real estate, and even timber. This grew the endowment from $1.3 billion in 1985 to $31.2 billion in 2020! Yeah, that deserved an exclamation point.
Obviously, Yale has outperformed its domestic equity index like the S&P index by a good margin over the past few decades, hitting nearly a 10% annualized return over the last 20 years. During that time frame, the stock market return was 6.2%.
Data Transparency and Accurate Reporting is Critical for Hedge Funds
We wrote three blog posts on the Archegos disaster, the GameStop short squeeze, and Infinity Q Swap Pricing debacle which provide interesting stories of funds who were literally blindsided when they lost visibility to their risk and endured massive drawdowns. Asset management firms have enormous pressure to become more transparent when it comes to any investment, particularly illiquid alternative investments. Several surveys conducted in the past year suggest that two-thirds of financial organizations are concerned about transparency and are looking for solutions to manage risk more effectively. Further, data sharing, analysis, and reporting have become critical for hedge funds to make certain guidelines are being met for client and regulatory demands.
Because of the issues that surfaced in funds with the GameStop investments, swap pricing, and massive leverage, investors are now demanding more information about their fund’s investments. Many are wanting to understand their risk more clearly and since alternative investments have valuation issues, complex fee structures, high volatility, and limited liquidity investors are wearier even if the fund promises higher returns.
Creating even more pressure for hedge funds to create more transparency, more consistent valuation methods, and better reporting, the SEC is asking for more accurate information about investments as well. Quoting investor recommendations from SEC.gov, “Hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion and Hedge funds may invest in highly illiquid securities that may be difficult to value. You should understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources. Valuations of fund assets will affect the fees that the manager charges.”
Solving the Transparency and Reporting Problem of Alternative Assets
Implementing a comprehensive, scalable, easy-to-use data information platform is an effective way to integrate alternative assets into a firm’s policies and procedures. By integrating all investing data in a single repository or database, the same way as they currently do with traditional investments, firms can assess their risk control needs consistently without patching together piecemeal reports. The same repository and reporting technology will identify gaps in transparency and reporting needs for the firm and address those as they scale the solution.
While we try and avoid commercials in our blog let’s use RyanEyes’ Collimate data warehouse solution as an example of such a partner technology that provides our asset management clients including hedge funds transparency, automation, and actionable insights. Collimate integrates with Ryan Eyes software to deliver our clients a refreshed, intelligent level of information across the front, middle, and back-office including their research, trading, accounting, and compliance solutions. While many data warehouses and analytics solutions are cumbersome, require training, and are difficult to use, Collimate provides clients with simplicity throughout the solution.
Big data and dashboard solutions that handle aggregating the data, compiling it using user criteria, and reporting the current positioning, risk, compliance, and other information is invaluable to hedge fund managers and fund administrators who need to focus on higher-level decisions rather than the painstaking task of assembling data.
Technology like Collimate is helping hedge fund managers to increase the accuracy of their predictions by using alternative data. As the last example, investment decisions can be made even using non-traditional information, such as geolocations, credit card transactions, and more. It was proven in a study by Statista that these hedge funds had better performance in the long run compared to others.
Alternative assets are certain to continue to account for a larger portion of hedge fund portfolios and because of the risk, valuation issues, and investor skepticism firms need to find solutions to create better transparency and compliance.
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