The role of multi-asset hedge funds to improve risk-adjusted returns

RAYHAAN JOOSUB Co-founder & Head of Multi Asset, Sentio Capital Management

What makes a good hedge fund? It goes without saying that a good hedge fund needs to achieve good performance relative to its stated objectives or benchmark. However, at Sentio we believe it’s just as important to ask the question, “How was that performanceachieved?” It’s not just good enough having a high return if the amount of risk taken to achieve that return is excessive, as this speaks to the unsustainability of those returns.

We believe that a good hedge fund, in addition to generating good returns, needs to fulfil two characteristics, which speaks to the quality of those returns:

1. Those returns need to be relatively uncorrelated to the natural beta of the underlying asset market like the equity or bond markets

2. Those returns need to display positive asymmetry, hence providing some measure of capital protection in down markets, and upside participation in rising markets.

Problems with single-strategy hedge funds

The problem with single-strategy funds like equity long-short or fixed-income hedge funds, is the relatively high correlation these single strategies have displayed relative to their underlying markets. These high correlations with asset market performance leads one to question the very merits of these hedge fund strategies as theyeffectively become high beta leveraged plays and defeat the very purpose of the ‘hedge’ in hedge funds.

A GOOD HEDGE FUND NEEDS TO ACHIEVE GOOD PERFORMANCE RELATIVE TO ITS STATED OBJECTIVES OR BENCHMARK

Compounding the problem in South Africa recently has been the highly concentrated nature of the positive performing stocks over the past few years, due to South Africa’s macroeconomic challenges and the recent COVID-19 crisis, which has made it difficult to build diversified hedge fund portfolios in the equity longshort space. Hence, managers have been taking ever-increasing risks to generate the same level of return achieved in the past. As a result, any asset market shock, like we have seen in March 2020, leads to severe drawdowns and negatively skewed, highly kurtotic return profiles, which is the antithesis of what hedge funds are all about.

We have also witnessed this phenomenon in fixed-income hedge funds, which have recently displayed negatively skewed, fat-tailed return profiles. This occurred during the Nene-gate crisis in November 2015, as well as the recent COVID-19 sell-off in March 2020. Market-neutral strategies have also depicted similar poor return profiles during periods of elevated volatility or higher correlations.

Multi-asset hedge funds are a better solution We believe that multi-asset hedge funds are a more sustainable product, in order to mitigate against the issues of single-strategy hedge funds. The ability to generate uncorrelated returns, using a multi-factor approach, together with relative value strategies across various asset classes, reduces the need to maintain unsustainably high beta exposure to any particular asset market and, thus, leads to better risk-adjusted returns. Focusing on multiple asset markets and multiple strategies also allows the fund managers to generate returns for the fund, even if one or two asset markets or strategies are going through periods of poor returns or high instability. This results in high-quality risktaking and improved risk-adjusted returns from multi-asset funds, versus single-strategy funds that are forced to chase returns in a narrow and concentrated universe.