A New Generation of Hedge Funds Can Provide Stability

Australia’s sovereign wealth fund CIO is betting hedge funds can help reduce risk.

While some investors see hedge funds as too risky to be part of a pension fund’s portfolio, Raphael Arndt sees the investment vehicle as a necessary tool to help reduce risk while providing uncorrelated returns.

In fact, the CIO of Australia’s A$166 billion ($125.3 billion) sovereign wealth fund, the Future Fund, has so much faith in his hedge fund strategy that  he has an exposure of A$22 billion, or more than 15% of the portfolio, in hedge funds.

“Hedge funds have an important portfolio role to play in generating returns that are uncorrelated to equity markets,” Arndt said last week in as speech before the Insurance Investment Forum in Torquay, Australia. “For the Future Fund, hedge funds have a very specific purpose in our portfolio.  This is to reduce risk—and in particular to provide returns during market environments involving prolonged periods of losses in equity markets.”

Despite the significant portion of the portfolio that is invested in hedge funds, it doesn’t conflict with the Future Fund’s mandate to achieve a return of at least inflation plus 4% per year over the long term, without taking excessive risk.

“I recognize that hedge funds have historically had a public relations problem, being associated with high fees, a lack of transparency, and perceptions of poor ethics and customer focus,” said Arndt.

But Arndt said this perception of hedge funds is a dated stereotype that he refers to as “hedge funds 1.0,” which has given way to what he calls “hedge funds 2.0”—a newly evolved generation of hedge funds.

“The ‘have a hunch, bet a bunch’ hedge fund manager is a relic of a bygone era, largely cleaned out by the GFC [great financial crisis] which exposed strategies which use high leverage and poor risk controls,” said Arndt.  “These have been replaced by institutional-quality investment processes.”

Arndt said the Future Fund’s hedge fund portfolio employs three types of strategies, which he refers to as macro-directional, alternative risk premia, and multi-strategy relative value.

Macro-directional can include directional trading, generally through the use of derivatives, or with a portfolio manager making decisions. Alternative risk premia is accessing return streams largely unrelated to financial market assets, such as reinsurance risk. And multi-strategy relative value is a collection of strategies designed to identify and capture temporary deviations in prices between liquid assets, such as equities and bonds.

“These strategies are designed to provide diversifying returns,” said Arndt, “so that in other parts of the portfolio we can invest into riskier assets like equities and illiquid assets such as infrastructure, private equity, and property, while maintaining an appropriate total portfolio construction.”

As of the end of March, the Future Fund reported a return of 8.5% per year over the last 10 years, compared to a target benchmark return of 6.7% per year during that same time period.

Arndt said that avoiding significant losses is particularly important for the Future Fund because, unlike most superannuation funds, it doesn’t receive inflows, and therefore doesn’t have the “luxury” of being able to invest into a down market. Using hedge funds allows it to provide diversifying returns and maintain portfolio flexibility in the event of a significant equity market drawdown.

“I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC type event in equity markets,” said Arndt. “The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.

“It’s time to re-examine what hedge funds offer,” he added. “The industry has evolved and improved, and features a new breed of managers that are different from their predecessors.”


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