Hedge Funds: Seeking Superior Risk-Adjusted Returns

Hedge fund strategies are structured to generate superior risk-adjusted returns. By implementing strategies that are intrinsically event-driven, or that offset some of the risks of investing in certain securities by shorting others, managers seek to deliver relatively steady absolute performance with little correlation to the market.

Industry-leading hedge funds historically generated outsized returns, and alternative investment managers now increasingly employ hedge fund strategies to reduce risk in client portfolios. Adding a hedge fund strategy to either a traditional portfolio or a portfolio of alternative investments may mitigate overall portfolio volatility. It may also provide stable risk-adjusted returns that enhance an investor’s potential to achieve their goals.

Hedge Fund Strategies

Hedge funds formerly attracted inflows by generating superior returns both on an absolute basis and relative to the market, by using debt and derivatives to leverage gains on client investments. But using leverage to take concentrated positions that performed poorly could cause losses in excess of a fund’s investment capital.

As a result of growing competition using similar strategies, the expected aggregate returns from hedge funds as an asset class have been re-rated substantially lower. In addition, liquidity inflows into public markets from central banks (since the Global Financial Crisis in 2009) led to increased correlations between investment returns within and across asset classes. The dispersion of performance across hedge fund managers remains wide, so achieving high relative returns increasingly relies on adept manager selection.

Hedge funds continue to employ an array of investment strategies across public equity, public credit, and multi-asset portfolios. By structuring funds that generate returns primarily through alpha (security selection) as opposed to beta (exposure to the market), managers seek to deliver relatively steady equity-like performance with lower risk (volatility) than the market.

Long/Short equity strategies seek to reduce market risk by “buying long” and “selling short” stocks with similar risk exposures, generating gains based on the fundamentals of each underlying business. This strategy is often biased to market gains, as not all of the long exposure is hedged by short positions. Equity strategies can also be market neutral by seeking entirely to offset long and short exposures.

Activist hedge funds seek to make investments in underperforming companies, intending to unlock value by being a catalyst for change. Gains may result from higher valuations, based on higher earnings potential driven by revised strategies under new management, or realized by a sale to a strategic or financial buyer.

Event-driven hedge funds implement strategies that pay off based on the expected outcome of a significant corporate event, the catalysts of which are often relatively independent from the broader market. For example, merger arbitrage strategies invest in companies that are the targets of recently announced transactions that haven’t been completed as they await regulatory and shareholder approval. Distressed debt strategies capitalize on bankruptcies and corporate restructurings, investing in struggling companies to help refinance and turn around their business models. These just scratch the surface of the types of events around which hedge funds can invest.

Credit hedge funds are often based on relative value strategies between the debt of different companies. Credit strategies can also include capital structure arbitrage between the senior and junior debt securities of the same issuer, or arbitrage between a single debt security or highly similar debt securities that are trading at different prices across multiple markets. Credit strategies tend to perform when credit spreads narrow.

Macro funds focus on economic trends that may affect stock markets, interest rates, commodity prices and currency exchange rates. These funds can be more volatile due to large directional bets that may not be adequately hedged, and due to the enormous complexity and uncertainty involved in determining the fundamentals of broad markets and economies. Quantitative funds (a modern evolution of macro funds) programmatically analyze historical market returns to create statistical models that trade around factors driving near-term performance, but that can change over longer time periods, potentially breaking the models.

The Benefits of Hedge Fund Strategies

Implemented together with other asset classes, hedge fund strategies can enhance portfolios by providing risk mitigation through uncorrelated returns. The benefits are often measured over time by how efficiently they generate returns relative to their reduced risk (their absolute returns). By providing resilience in market downturns, hedge funds can be extremely accretive to long-term portfolio outcomes when their healthy balances throughout a downturn are redeployed into other asset classes in the portfolio that have become significantly dislocated from fair value. Thanks to the liquidity of their underlying investments in mostly publicly traded assets, this reallocation process is quite feasible compared to realizing and shifting value from more illiquid alternative asset classes.

Diversification is a strategy that constructs portfolios of investments to balance performance based on their different risk profiles and return potential. The goal is to achieve strong returns while mitigating downside risk due to poor performance from concentrated positions in certain securities or asset classes.

By diversifying portfolios, the positive performance of some investments may offset the poor performance of others based on their underlying fundamentals and investor sentiment. Diversification also takes into account both how investments respond differently relative to each other and (in some cases) in opposite directions due to market volatility.

The degree to which investments change in value — relative to or inversely from each other — is known as “correlation.” The less correlated a portfolio’s investments, the greater the diversification benefits.

Diversification can be achieved by investing within asset classes and across different asset classes. Hedge funds are an excellent tool for achieving diversification in that they are intentionally constructed to be uncorrelated to other market-driven asset classes and in that they invest in different types of securities across equities, credit, and multi-asset portfolios.

Poolit Provides Access to Hedge Fund Strategies to Anchor Portfolio Returns

Historically, hedge fund strategies were only accessible to institutional investors such as university endowments and pension plans, or to ultra-high-net-worth individuals considered to be “qualified purchasers” with a net worth of over five million dollars (excluding their home equity). Individuals also lacked access to fund manager distribution channels or their large wealth management partners to make such investments.

We are convinced that everyone should have the opportunity to generate meaningful wealth through a diversified portfolio with exposure to premier alternative investment funds. So, we left Wall Street to rebuild it for you. Poolit is capitalizing on changing regulations to offer accredited individuals the opportunity to invest in the same potential risk-adjusted returns offered by the hedge fund strategies previously accessible only to institutions and high-net-worth investors.

Partnering with professional investment managers through a registered fund, Poolit’s hedge fund offering will provide broad exposure to hedge fund strategies in a single investment. To further democratize alternatives, the fund will also allow for no minimum investment.

To build your wealth and realize your potential, get early access to Poolit. Be the first to know about new alternative investments by joining our waitlist at: https://www.thepoolit.com.