Download Using Low Volatility Hedge Funds as a Complement to Fixed

Using Low Volatility Hedge Funds as a Complement
to Fixed Income Allocations
January 2017
cidel.com
EXECUTIVE SUMMARY
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As interest rates begin to rise, risk in traditional
fixed income portfolios rises as well
HEDGE FUNDS – NOT JUST EQUITIES!
Negative November and December fixed income
performance an eye opener to many investors.
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One potential solution is a portfolio of credit-focused
hedge fund managers that can reduce interest rate
risk and deliver a fixed income-like risk/return profile
– but investors must be aware of liquidity and other
constraints
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OVERVIEW
Traditional balanced portfolios comprised of a mix of equities and fixed income securities have been the beneficiary
of a thirty year bull market in bonds, which has provided
a low-volatility source of capital appreciation in addition
to the coupon payments received. However, with interest
rates now rising off these historic lows, investors must question the true risk inherent in the traditional 50/50 mix. Following the surprise election of Donald Trump and the Federal Reserve’s raising of rates in December, investors were
treated to a reality that they have not had to face in a long
time: bond prices are inversely correlated to interest rates,
and that it is indeed possible for bonds to drop in value. In
November, the Barclays Aggregate Bond Index was down
2.37% while the DEX Universe bond index dropped 2.07%,
their most significant drawdowns in recent memory.
Credit Long/Short
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}}Fixed Income Arbitage
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At Cidel, we do not consider hedge funds an asset class
– they are simply a type of active manager participating in
various asset classes, ranging from equities to currencies
to commodities. Focusing on the fixed-income and credit
markets, there are a number of strategies that allow good
portfolio managers to take advantage of both long and short
investment ideas. For example, a credit long/short manager
might purchase a bond that he or she thinks is undervalued,
while at the same time shorting a different bond they think
is overvalued. Additionally, that manager would have broad
discretion to be under invested (i.e. have a large cash position) when they don’t think there are many opportunities
available to them. Most traditional investment managers do
not have this type of flexibility, as they are only permitted
to be long securities and must be fully invested at all times.
Building a portfolio of managers with uncorrelated and diverse return streams can protect capital in difficult investment environments (See Figure 1).
SO WHAT TO DO?
One solution is to invest in strategies and managers with
the tool kits to minimize risk and potentially profit in a rising-rate environment. To many investors, the term “hedge
fund” conjures up a highly leveraged ultra-aggressive equity
fund that can massively beat the “market” in some years,
but also get taken to the proverbial wood shed in others.
However, the hedge fund world is actually made up of a
wide range of underlying investment and trading strategies,
many of which have nothing to do with the equity market
at all.
Distressed Credit
Convertible Bond Arbitage
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Hedge Fund Performance in Raising Rate Environments
14%
HFRI Fund of Funds Composite
Barclays Aggregate Bond Index
11%
8%
5%
2%
-1%
-4%
June-03 to May-04 June-05 to Jun-06 Jan-09 to Jul-09 Sep-10 to Mar-11 May-13 to Dec-13
Figure 1
Q4 2016
January 2017
cidel.com
ISSUES TO CONSIDER
OBJECTIVE
DIVERSIFICATION
The first thing to consider, as with any investment, is what is
the objective of the hedge fund portfolio? If you can’t articulate the exact role an investment is playing in a portfolio,
odds are good it should not be there. As a general starting
point for fixed income complements, Cidel recommends
an objective of short-term interest rates plus a premium
of 200-400 basis points depending on the investor’s risk
profile. The target volatility would be in line with historical
fixed income volatility of 5%. It is paramount that investors
focus on the purpose of the portfolio and not the performance of unrelated indexes, particularly equities.
In either option, we view building a portfolio of hedge funds
as similar to building a portfolio of stocks – you need to be
diversified but not so diversified you arbitrage away all your
opportunity for returns.
VEHICLE
Once the objective is established, one can make decisions
about the type of hedge fund strategies to include. For
many investors, a fund of funds, a structure in which a manager selects a portfolio of multiple individual hedge fund
managers, allows you to get broad and diversified exposure
to a given objective without taking the idiosyncratic risk of
allocating too much of your capital to one individual manager. For larger investors, a customized segregated account is
the best route, allowing the investor to create a more finely
tuned portfolio and have more discretion on position sizing
and factor exposures.
DUE DILIGENCE
Additionally, hedge fund due diligence is extremely time
intensive and difficult. Cidel’s multi-asset team has a proprietary process to narrow down the hedge fund universe,
analyze potential managers and monitor our current managers.
LIQUIDITY
The final important factor to consider is liquidity. Most
hedge funds provide monthly or quarterly liquidity, and
some have more prohibitive lock-up periods. This contrasts
with traditional fixed income, which tends to be highly liquid. Therefore, clients must be cognisant of this liquidity
contrast and analyze the impact in regards to their overall
portfolio and cash flow requirements.
Cidel provides clients leading fund of fund and customized hedge fund advisory
managed account services. Please contact your Wealth Consultant to learn more.
*Cidel is an operating name of Cidel Asset Management Inc.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information contained in this document
has been compiled by Cidel Asset Management Inc. from sources believed to be reliable, but no representations or warranty, express or implied, are made by Cidel Asset Management Inc. as to its accuracy, completeness or correctness. The
opinions expressed are as of the date of this publication and may change without notice and are provided in good faith, but without legal responsibility. Cidel Asset Management Inc., carrying on business as Cidel, Cidel Financial Group, Toron Asset
Management International, (“Cidel”) is registered as a portfolio manager, investment fund manager and exempt market dealer in Ontario. Cidel is also registered as a portfolio manager and exempt market dealer in the provinces of Alberta, British
Columbia, Manitoba, New Brunswick, Newfoundland and Labrador, Nova Scotia, Prince Edward Island, Quebec and Saskatchewan.This document may not be reproduced, distributed or published by any recipient hereof for any purpose.