Multi-strategy – the ultimate diversifier?
Multi-strategy hedge fund portfolios have emerged as one of the most popular investments in recent years, rapidly growing in size to represent approximately 20 per cent of the hedge fund industry’s total assets under management – or some USD 872 billion, according to HFR data. It's a trend we believe will continue as investors place ever more emphasis on consistent performance and diversification, two key features of multi-strategy funds. According to recent surveys, demand for such funds stands at a multi-year high.1
The popularity of such strategies testifies to growing doubts over the resilience of the traditional balanced portfolio, in which assets are spilt more or less evenly between bonds and stocks.
Traditionally, diversifying investments across mainstream asset classes has been viewed as the most effective way to tackle the peaks and troughs of financial markets. Yet the approach of combining long positions in bonds and in equities is far from fail-safe. When stocks and bonds sell off at the same time, the thesis falls apart. That occurred in both late 2021 and this year, with the broad market sell-off characterised by a spike in cross-asset correlations.
The correlation between stocks and bonds varies significantly over time. Although it is not a direct relationship, inflation could be one of the factors behind the shift in cross-asset correlations. In the two decades before 2000, the 3-year rolling correlation between the US S&P 500 equity index and US Treasuries was positive, while inflation expectations averaged 4.5 per cent (see Fig. 1). In the last 20 years, the correlation has been negative, which has coincided with a decline in inflation expectations to an average of 2.0 per cent. Now, inflation expectations are moving up once again and therefore correlations may turn less negative in the future.
With inflation rising to levels not seen in decades, there is arguably a greater need to spread a portfolio's capital across a broader range of assets. One of the solutions is to allocate some capital to investments whose returns are not correlated with those of mainstream asset classes.
That’s where the multi-strategy approach can help. Multi-strategy funds aim to generate consistent returns by investing in a number of strategies that generally exhibit minimal or negative correlation, both to one another and to broad market indices. This allows investors to gain access to different investment styles (across asset classes, geographies and sectors), each managed by experts in that particular field – through one single fund structure.
In addition to their inherent diversification advantage, such structures are also cost efficient as there is no double layer of fees and no so-called netting risk for investors. This means that, unlike a collection of single strategy funds, multi-strategy funds charge fees on the overall net performance of the sub-strategies.
Voice of experience
Pictet Asset Management was one of the pioneers of the multi-strategy approach in Europe, launching our Alphanatics strategy back in 2004.
Our goal at the time was to develop a strategy that minimised market risk and maximised active risk. That meant being ready to give up some risk premia (by limiting beta and interest rate duration, for instance) in exchange for a greater chance of stable returns.
We also wanted to harness the most attractive qualities of of hedge funds or funds of hedge funds - exposure to a broad, investable universe, unconstrained long and short investing, the ability to leverage - but none of their shortcomings, such as excessive reliance on carry and style biases, uncontrolled and excessive leverage, liquidity mismatch. This philosophy is as relevant today as it was when we devised it..
During the past 18 years, we have fine-tuned our approach, establishing a track record of delivering stable, alpha-driven returns to investors and growing the strategy to EUR4.7 billion. Today, our allocation spans market neutral and event driven equity strategies on a global, regional or sector basis, as well as fixed income relative value and special situations strategies, including sovereign debt (DM and EM), credit (investment grade, high yield and distressed), and foreign exchange (see Fig. 2).
By carefully combining strategies whose returns are not correlated to - or have a low correlation with - one another, it is possible to construct a portfolio with higher risk-adjusted returns than the individual components. Indeed, on average, 73 per cent of the individual segments in the portfolio have a lower risk adjusted return than the fund, while the average correlation between our underlying strategies is usually below 0.1.
There are periods when some individual segments have a higher risk return profile than the overall fund, but the pattern changes over time.
As well as having expanded the range of strategies we invest in, we have also finessed our risk management, deploying new tools and risk models that have evolved over time. A key consideration is the relationship between strategies and in particular the correlation among them during periods of market turbulence. The manager of a multi-strategy fund can have a comprehensive view of the portfolio and its various instruments and is therefore well-positioned to identify problematic correlations or overlapping bets and exposures.
Although at portfolio level we aim for a large fraction of our total risk to be idiosyncratic (or investment-specific), at sub-strategy level we recognise that it is too expensive to attempt to completely eliminate risks associated with factors (such as style). We are therefore careful to combine strategies that have different or even offsetting residual factor risks, using a multi-factor risk model. This results in a portfolio that has superior risk adjusted returns. For instance, if some of the equity strategies we invest in have a growth tilt at a given point in time, this can be offset by increasing allocation to those with a value tilt.
We have also developed a proprietary system that helps us monitor crowded positions (where a large number of investors have taken a particular position, making it potentially vulnerable to sharp moves) and another that tracks our exposure to various themes using brokers’ thematic baskets (eg winners and losers from the work from home trend).
All this results in a low sensitivity to market movements (see Fig. 4).
A distinguishing feature of our approach is the flexibility afforded to the segment managers. Our experience shows that it takes at least three years to judge a strategy’s capacity for alpha generation, and that, over the long term, it pays to back the proven managers even during periods of significant market turbulence and when it has been difficult to generate alpha. It’s equally critical that all managers are aligned with Pictet’s values. This includes the way they think about portfolio and risk management. Some of our most successful segment managers have been managing capital in Alphanatics for more than 15 years.
Given the success of multi-strategy funds, the competition to attract high quality, talented portfolio managers has become fierce.
In this context, and as part of our constant search for new alpha capabilities, we have added ten new strategies to our portfolio since 2018, and are planning to add a couple more this year. We have also closed a few.
Multi-strategy funds, like Alphanatics, can be used by investors in a number of ways, including as a diversifier for a global portfolio or as substitute for part of a fixed income allocation.
We believe that the diversification and capital preservation capabilities of a multi-strategy fund will be absolutely crucial in the future, as the traditional 60/40 portfolio approach is challenged.
 Morgan Stanley Quarterly Vantage Points, February 2022