ANALYSIS: Hedge funds should be reclassified by returns - bfinance
6th December, 2024|Luke Jeffs
A hedge fund expert has argued for a reclassification of hedge funds by their returns rather than the strategies they deploy, arguing investors are more interested in returns than how funds achieve them.
Toby Goodworth, a managing director and head of liquid markets at bfinance, which advises investors, said the established definitions of hedge funds are focused on the wrong things.
He told FOW: “When most people assess hedge funds, they look at the underlying strategies and the investment processes that the managers pursue which can bundled into a dozen strategies and some twenty plus sub-categories.”
Hedge fund administrator Citco, which supports alternative investments worth more than $2 trillion (£1.56tn), organises the hedge funds it administers into eight groups: Arbitrage; Emerging Markets; Equities; Event Driven; Fund of Funds; Global Macro; Multi-Strategy; and Hybrid.
Goodworth added: “That is fine but it doesn’t really help investors with portfolio construction. Those labels explain the investment process but they don’t explain the style of returns which is ultimately what matters to investors.
“The point of hedge funds is you use them for return streams you can’t get from traditional risk assets so they need to be demonstrably different. If you start to think about hedge funds in those terms there are basically three different return style groups: convex divergent returns, market independent and directional.”
The bfinance managing director said convex divergent funds are interesting because they perform well in choppy markets. “Convex divergent strategies aim to deliver positive long-run return but often delivering the bulk of these returns in more unstable and volatile market environments which is often when traditional risk assets draw-down. In this sense, they provide what we call ‘heroic diversification’ which is where they deliver larger returns when your traditional risk assets are failing.”
He said convex divergent funds performed particularly well in 2022 when bond and equities indices were down double digits but hedge funds such as Commodity Trading Advisors and trend-following specialists delivered 20-30%.
Goodworth continued: “The market independent return style speaks for itself. That is a more reliable, consistent return style where you expect to get similar returns irrespective of the underlying market conditions. Typically you are looking at hedge fund strategies that have low or no equity market beta. That is useful but the downside is it doesn’t have any convexity so it’s not going to help you out in tough times more than it helps you out in normal times.”
He added: “The third bucket is directional returns so these are hedge fund strategies where beta features in the return profile (often because the alpha sought cannot be easily isolated from the beta, e.g. some styles of Event Driven investing). Anything with beta greater than .4, most investors in hedge funds would consider that to be directional.”
Flows into hedge funds turned positive in October, according a report last month by hedge fund administrator Citco which suggested its funds reported subscriptions of $11.4bn versus redemptions of $10.6bn.
The Citco hedge funds also recorded their eighth successive quarter of positive returns in the three months to the end of September, with funds achieving a quarterly return of 3.2% which took hedge fund performance this year into double figures.
Goodworth added: “We have seen that the first two categories - the convex diversifiers and the market independent diversifiers - are more useful in providing differentiated return streams for a traditional portfolio and that is where all the hedge fund activity has been recently.”
Stepping back, Goodworth said demand for hedge funds has picked up this year as investors look to diversify away from equities which are expected to fall back from their current record highs.
He said: “Hedge fund activity switched on in Q4 2023 and through this year the interest in hedge funds has really picked up. We’ve seen appetite for liquid alts and hedge funds coming more from wealth management and family offices than pension plans recently and, where the interest has come, it has been almost entirely in the convex divergent category and the market independent categories.”
Investors have been increasing their hedging activity this year, with large derivatives exchanges again reporting record volumes after a strong 2023.
CME Group, which operates various exchanges, has had in 2024 five of its busiest ten months ever, according to FOW Data, including its second busiest month ever for volume in August, when the Chicago-based group traded 696.9 million lots.
