Hedge Funds as Diversifiers in Institutional Portfolios - Commonfund

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
1
Hedge Funds as Diversifiers in
Institutional Portfolios
Commonfund Hedge Fund
Strategies Group
August 2013

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
Table of Contents
Contents
Executive Summary.......................................................... 1
Introduction..................................................................... 2
Correlation and the Growth of the
Hedge Fund Industry....................................................... 3
Alpha Generation............................................................. 4
Diversity of Beta Exposure............................................... 5
Authors
Kristofer Kwait
Managing Director
kkwait@cfund.org
John Delano
Director
jdelano@cfund.org
Justin Santana, CAIA
Director
jsantana@cfund.org
Commonfund Hedge Fund Strategies Group
15 Old Danbury Road
Wilton, CT 06897
203.563.5000
About Commonfund
Hedge Fund Strategies Group
Commonfund Hedge Fund Strategies Group is a division of
Commonfund Asset Management Company, Inc., a wholly
owned subsidiary of Commonfund. Since our initial hedge
fund investment in 1982, Commonfund has played a fiduciary
role in selecting hedge fund investments for our clients. We
employ an institutional investment management philosophy
and process in a fiduciary framework to help clients with
hedge fund allocations through the creation of innovative
multi-manager funds and customized separate accounts.

Hedge Funds as Diversifiers in Institutional Portfolios August 2013 1
Executive Summary
In the not too distant past, hedge funds were often considered
mysterious, exotic, and elusive investment vehicles that
revealed little about their methods of generating return.
As the industry has matured and standards of transparency
have evolved, that perception seems to have mostly faded.
Meanwhile, other broad tags of disapproval, such as that
hedge funds are expensive, glorified indexers - in essence,
the opposite of exotic and mysterious – have more recently
taken their place. While these extremes reflect some degree of
hyperbole, they also reflect legitimate concerns and important
considerations for hedge fund investors: avoid investments
that are inaccessible and not able to be understood; avoid
constructing a hedge fund allocation that is redundant and
inefficient in a portfolio. But for most, the reality of hedge
fund investing is very much in-between: the inaccessibility and
mysteriousness of hedge funds is often overstated, and their
value as diversifiers is often understated.
Hedge funds continue to present a compelling value
proposition to institutional investors as volatility dampeners,
absolute return vehicles in certain cases, and as less-correlated
sources of return. As an investment class they have historically
demonstrated the ability to generate superior, risk-adjusted
returns to the broad market. Even in periods when hedge
funds underperform the broad market they still provide
measurable value to a portfolio. After all, if completely
confident in the direction of the market, an investor would not
need hedge funds or any other source of diversification.
• The growth of the industry has led to an
increased number of correlated managers,
but it has also led to an increased number of
uncorrelated managers. In fact, the single largest
area of growth over time has been in the group
of managers with the lowest percentage of their
returns explained by those of the broad equity
market. For a thoughtful, strategic investor,
this diversity provides the opportunity to attain
portfolio diversification independent of market
direction.
• The long-term, alpha-based case for hedge
funds remains strong, despite recent declines in
alpha coinciding with unusually adverse market
conditions for security selection generally.
• In addition to significant alpha, hedge funds
also offer a diverse array of systematic or market
exposures.
• Hedge funds are not a monolithic entity, nor
should they be considered a single and uniform
investment class. They are highly diverse both
among and within strategies.

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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Hedge Funds as Diversifiers in Institutional Portfolios
Introduction
Investors allocate to hedge funds for a wide array of reasons.
Some seek equity or fixed income complements or substitutes,
others pursue volatility dampeners and sources of less-correlated
return, while others view hedge funds as a means of access
to less-liquid or more complex securities. All of these reasons
can in some form be captured within a single category – risk.
And for many, equities represent the dominant risk in their
portfolios. According to the 2012 NACUBO-Commonfund
Study of Endowments (NCSE), the average U.S. endowment
has 46 percent of its assets invested in equities, and significantly
more on a risk-weighted basis. One of the primary
roles of hedge funds for the typical institution, then, is often
to provide a source of return that is only modestly correlated
with the broad equity market.
Within the public sphere, however, assessments of hedge
fund performance tend not to be as nuanced. Commentary
like “…the S&P 500 was up 16 percent in 2012, but hedge
funds, private investment vehicles run by what many consider
to be top managers, were up only 8 percent on average…” is
often characteristic of financial news commentary. While the
particular flavor of media attention to hedge funds partially
reflects backlash against a perceived element of exclusivity, it
is important to note that these characterizations come with
embedded assumptions that may be inconsistent with many
investors’ goals.
One implicit assumption, for instance, is that the success of a
hedge fund – any hedge fund – should be viewed as a standing
bet on the direction of the S&P 500 Index. This would
presume that a hedge fund manager attempts to have long
exposure to the equity market when it is going up and short
when it is going down. Another is that hedge fund managers
ought to be perpetually ahead of the most widely-followed,
passive equity market index given their elite and talented
status. In both cases, the hedge fund universe is understood
narrowly in terms of two monolithic entities: “Hedge Funds,”
capital H, capital F, and “The Market,” capital M.
Actual (as opposed to theoretical) hedge fund investing,
however, requires thoughtful, careful decision-making with
significantly more context around strategies and their risk and
return properties.

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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Correlation and the Growth of the
Hedge Fund Industry
One charge often directed at hedge funds is that they offer
little more than repackaged equity market risk even as skeptics
acknowledge that hedge funds have historically delivered
robust, uncorrelated returns within certain markets. However,
many also assert that the growth of the hedge fund industry
has built up industry-wide correlation on a large scale, with
alpha increasingly scarce and fleeting, and with inevitably
overlapping trades eroding diversification benefit. At a glance,
the uptrend of broad hedge fund index correlation with the
S&P 500 Index (here, the HFRI Fund weighted Composite
Index) would seem to support these claims.
As the hedge fund universe has grown, competition for capital
and the hunt for sources of return among individual managers
have created an opportunity for more diversification, not
less; in fact, a look within the broad hedge fund universe
contradicts the notion that hedge funds are solely driven by
the equity markets. For instance, a universe-wide look at
correlations reasserts that the risk and return properties of a
hedge fund allocation are not simply a function of the broad
equity market. Below are rolling 12-month R-Squared (a
measure of the total share of return explained by the S&P 500
Index) of constituents of the HFRI Fund weighted Composite
Index, representing all four major strategy groups – Equity
Hedge, Event-Driven, Macro, and Relative Value – to the S&P
500 Index.
Aggregate Hedge Fund Relationship to U.S. Equity Market
Rolling 12-month R-sq., HFRI Fund Weighted Composite to S&P 500 Index
Janaury 1993- April 2013
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08 Jan 11
Source: HFRI and Commonfund Hedge Fund Strategies Group
The hedge fund universe has indeed grown by several-fold
since the “mystique” days of the early 1990s. Quantitative
evidence suggests that many funds are largely vehicles for
a form of broad market exposure (beta), and on an average
basis the typical hedge fund universe constituent seems to
have become increasingly correlated with the equity market
over time. However, for the prudent hedge fund investor, the
correlation properties of the average hedge fund – represented
by the HFRI Index – are not necessarily relevant to a
thoughtful, thorough selection process.
Number of Reporting Managers in the
HFRI Fund Weighted Composite Universe
Managers by Strategy | January 1992 - February 2013
3000
2500
2000
1500
1000
500
Macro
Relative Value
0
Event-Driven
Jan 92 Jan 95 Jan 98 Jan 01 Jan 04 Jan 07 Jan 10 Jan 13
Source: HFRI and Commonfund Hedge Fund Strategies Group
Total
Equity Hedge
Within the HFRI Fund weighted Composite index, as the
total number of funds has risen, the number of funds highly
correlated with broad equity market has also risen – but
so, too, has the number of uncorrelated funds. In fact,
partitioning the manager universe on a 12-month rolling basis
in terms of R-Squared to the equity market in 10 percent
increments, from December 1992 to December 2012, there
was a greater increase in the number of managers with less
than 10 percent of return explained by the S&P 500 Index
than any other group.

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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More Correlated Managers...and More Uncorrelated Managers
Number of
Managers
1000
800
600
400
200
0
Dec-92
Dec-97
Dec-02
Dates
Dec-07
Dec-12

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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An additional step is to substitute an index representing
“hedge fund beta” itself for the S&P 500 Index. The Goldman
Sachs Absolute Return Tracker ETF (GJRTX) is one of the
most recognized hedge fund replicators, and the chart below
demonstrates that on a single-factor basis the large majority
(approximately 84 percent) of the reporting hedge fund
universe has produced positive alpha on a relative basis.
HFRI Fund weighted Universe
Beta(x), Alpha (y) to Goldman Sachs Absolute Return Tracker
June 2008 - February 2013
8.00%
6.00%
4.00%
2.00%
-2.00%
-4.00%
84% Positive Alpha
0.00%
-6 -4 -2 0 2 4 6 8 10 12
Source: HFRI, Goldman Sachs, Bloomberg and Commonfund Hedge Fund
Strategies Group
Does the result suggest that the overwhelming majority of
hedge funds produces positive alpha, after accounting for
market risk, to the rest of the hedge fund universe? That
certainly seems unlikely. The strength of this result must
be at least partially attributable to familiar database biases,
like survivorship among reporting members, along with the
replicator itself - designed to produce hedge fund beta and not
alpha. The result does, however, strongly suggest that stating
that the universes of investable hedge funds are either
1) simply interchangeable, or 2) simply vehicles for market risk
is greatly overstated.
Diversity of Beta Exposure
In addition to uncorrelated returns and alpha, the hedge
fund value for institutional investors is diverse market (beta)
exposure. Across the hedge fund universe, specific strategies
and areas of specialization draw managers into different
markets using different methods. This results in significant
diversity in the statistical properties of historical returns.
To illustrate this concept, below are two sets of multi-factor
“beta” profiles for individual managers reporting to the HFRI
database. The first chart shows results for Equity Hedge
managers vs. common equity factors, the second for Relative
Value and Event-Driven managers vs. credit-related factors.
In both cases, the horizontal (x-) axis shows the “beta” or
systematic exposure to one factor and the vertical (y-) axis
shows simultaneous exposure to another.
HFRI Equity Hedge Universe
Beta to Regional Broad Market(x), Regional Value (HML) (y)
Factors
Three years ending December 2012
US
Asia
Europe
0.0
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0
Source: HFRI, PerTrac and Commonfund Hedge Fund Strategies Group
HFRI Relative Value and Event-Driven Universe
Beta to Parallel Shift Down(x), Flattening (y) in Credit Spreads
(Principal Component Factors)
Three years ending December 2012
6.00%
4.0
3.0
2.0
1.0
-1.0
-2.0
-3.0
4.00%
2.00%
0.00%
-1.50% -1.00% -0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50%
-2.00%
-4.00%
Source: HFRI, BoAML and Commonfund Hedge Fund Strategies Group

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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In the equity hedge example, the first factor is sensitivity to
a regional broad market (S&P 500, MSCI Europe, MSCI
Asia ex-Japan) applied to managers based on their region of
focus. In addition to broad market exposure, managers exhibit
different biases to fundamental equity valuation factors.
Exposure to such biases in stock selection is often considered
a form of systematic risk; in the case of value it makes sense to
consider this a “beta” to a regional value factor. In this case,
the regional value factors are based on academic researcher
Kenneth French’s Fama/French benchmark factor HML 2 .
Particularly notable here is the dispersion of the systematic
risk exposures. If managers were in fact best considered a
monolithic undifferentiated mass, the plot points would
be tightly concentrated in a single area. Instead, they are
scattered across the surface of the chart.
The second chart makes a similar case within the Relative
Value and Event-Driven universes, showing sensitivity to
two forms of systematic risk exposure within corporate
credit-spreads:
1. a parallel shift down in spreads across the entire credit
ratings spectrum (i.e., credit spreads are tightening to a
similar degree in all ratings categories) and,
2. a “flattening” in spreads (i.e., the spreads of lower-rated
credits are tightening more relative to higher-rated
credits, suggesting outperformance of riskier credits).
Managers to the right of the vertical axis have a statistical bias
towards a broad credit rally, and managers above the horizontal
axis towards outperformance in lower-quality credits (plot
points in the upper right quadrant suggest positive sensitivity
to both factors). While the majority of constituents in the
two strategy universes are generally neutral-to-long credit (as
opposed to short), and are largely expected to perform better
in environments characterized by outperformance of lowerrated
credits, the broad scattering of plot points also suggests
significant dispersion in the beta risk profiles of the managers.
This diversity of exposure is another critical aspect of the
diversification benefit that hedge funds can offer institutional
portfolios: hedge funds are diverse and come in many forms
with respect to their systematic risks.
2
SMB and HML, or the Fama/French factors, are constructed based on
size- and book-to-market. HML (High Minus Low) is the average return on
two value portfolios minus the average return on two growth portfolios. SMB
(Small Minus Big) is the average return on three small portfolios minus the
average return on three big portfolios. For more detail, see http://mba.tuck.
dartmouth.edu/pages/faculty/ken.french/data_library.html, and see Fama and
French, 1993, “Common Risk Factors in the Returns on Stocks and Bonds,”
Journal of Financial Economics, for a complete description of the factor
returns.
Endnote to HFRI Relative Value and Event-Driven Universe multifactor
“beta” profile:
Credit beta factors used in scatter chart are based on principal
components of correlation matrix of 10 option-adjusted corporate
credit spreads, with Bank of America Merrill Lynch credit spread
indices used as inputs. Loadings are represented below.
• Parallel shift: spreads narrow across the ratings/quality
spectrum
• Flattening: spreads on lower-rated credits narrow more
than those of higher-rated, potentially with widening
among higher-rated. Scenario may be interpreted to
represent a migration to higher-risk, higher-yielding credit
that is uncorrelated with the parallel shift factor.
Two forms of shifts in credit spreads represented by
Principal Components
0.8
0.6
0.4
0.2
0
-0.2
-0.4
Flattening/Steepening
Parallel Shift
AAA AAA-AA AA A A-BBB BBB BB BB-B B CCC

Hedge Funds as Diversifiers in Institutional Portfolios August 2013
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