It wasn’t too long ago that the hedge fund industry was widely deemed to be in terminal decline. With stock markets on a record bull run, investors poured money into low-cost passive index trackers and the days of the “2-and-20” manager seemed to be numbered. In the three years between 2017 and 2019, an estimated USD200 billion of investor capital exited hedge funds.1
The doomsayers spoke too soon. Hedge funds emerged from the pandemic crisis in a position of almost unprecedented strength and, despite lingering uncertainty, money has poured into the industry in 2021. Hedge fund assets reached an all-time high of USD4.07 trillion in June 20212, and trading profits soared to more than USD550 billion over the preceding 12 months3, the strongest performance since before the 2008 financial crisis.
For the high-net-worth investor, hedge funds have considerable appeal, particularly now that equity markets appear to be more fragile and inflation concerns are beginning to mount.
Hedge funds offer more flexibility than many traditional investment options, partly because they do not attract the same level of regulatory oversight. They also present greater diversification opportunities; managers are able to deploy a far broader range of strategies to reduce risk and amplify returns, which makes them especially nimble during times of volatility and uncertainty.
An effective hedge fund manager will, for example, be able to capture shifts in the prevailing winds of investor sentiment – burgeoning interest in value over growth stocks, the rise of ESG investing, the SPAC boom, a resurgence in bond fund inflows, a revival of optimism in emerging markets – that are beyond a manager tied to a fund theme or strategy.
“Hedge funds offer a far greater range of strategies and investment styles than the long-only investment world can provide, making them a highly effective tool for diversification,” says Peter Gray, Head of Hedge Funds & Liquid Alternatives, Bank of Singapore. “The ability to short and lever positions also provides sources of return that are differentiated from traditional assets. Hedge fund managers can invest in a largely unconstrained manner, and this freedom and flexibility provide exposure to financial instruments, derivatives and markets that are difficult if not impossible to include in a portfolio without hedge funds.”
Investors still need to be aware of potential risks, however, which may be obscured by the recent headline-generating surge of profits.
Some funds employ a highly concentrated investment strategy, which exposes them to equally concentrated losses. And while hedge funds are agile, their ability to execute rapid entries and exits doesn’t apply to investors, whose funds are usually locked up for a specific period.
Also, the industry’s use of leverage and long/short strategies still makes hedge funds vulnerable to heavy losses and occasional collapses. Recent examples such as the folding of Archegos Capital Management and the GameStop activist attacks have highlighted those vulnerabilities, and hence the importance of manager and strategy selection.
Picking the right managers
While the broad flexibility of hedge funds can reward the most talented managers with impressive returns, it can also punish less diligent ones. Thus investors need a rigorous process for evaluating hedge funds and managers.
“The ability to lever, short and invest in less liquid securities generates risks that are not a part of mutual fund investing,” Gray says. “So, when looking at hedge funds, it is crucial to be working with the most talented and risk-conscious managers in the business. A high-powered sportscar can do amazing things in the hands of a talented and experienced Formula One driver, but an amateur trying to drive the same car is likely to have an accident in short order.”
Bank of Singapore has global access to an exclusive network of managers, overseen by a team that has vetted more than 100 funds that have a track record of low sensitivity to traditional assets and strong performance in high-volatility environments.
The Bank of Singapore advantage
Bank of Singapore has a differentiated approach to portfolio construction, and follows a robust framework to identify and perform due diligence on truly differentiated managers – including both emerging and established “marquee” managers that are closed to new investors.
“Hedge fund investing is all about a manager’s ability to generate alpha,” Gray says. “There are many ways to define that term, but at a general level, you can think of it as the manager’s skill in security selection and timing. These will naturally vary over time even between managers engaging in the same strategy. So, we always advise investors to try to have at least some level of diversification in their hedge fund portfolio, both to enhance returns across the cycle as well as to reduce single-manager risk.
“Our presence in various financial centres around the world is one thing that helps us stay on top of what is happening in the hedge fund universe. For example, we have a branch in Hong Kong staffed with colleagues who know the space which enables us to track China-centric hedge funds at a close level. Many of our clients are themselves involved in asset management and even hedge fund investing, so our ability to speak with them informally and exchange ideas is also very helpful.”
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