A paradigm shift within the asset management industry is at hand. Disappointing performance across both traditional and alternative investment approaches has opened the door for change. The barriers between traditional asset management and alternative asset management are rapidly blurring. New products that marry the investment goals of traditional active investment mandates with the trading strategies utilized by the best alternative managers are emerging, and institutional investors are taking notice. This innovative hybrid approach seeks to solve the return conundrum created by the low return environment brought on by years of easy monetary policy globally.
Active long-only asset management has performed poorly in recent years, rattling investor confidence in their traditional investment approach. The growth of the hedge fund industry has ‘stolen’ some of the alpha once captured by active long-only managers. As a result, passive investments have taken significant market share from what was once an active-only world. Nonetheless, for most of 2016, hedge funds and funds of hedge funds have come into the spotlight as their value proposition of either better performance or diversified returns is being challenged. Many managers failed to deliver the diversifying or ‘alternative’ performance that they had asserted was possible. In addition, clarity surrounding investment mandates, which is key to successfully measuring a manager’s performance, is currently lacking within the industry, creating an identity crisis.
Along with these structural shifts, most institutional investors are failing to achieve their targeted investment returns, creating the opportunity for change. One promising innovation will be investment approaches that integrate hedge fund techniques into more traditional equity or fixed income mandates, thereby redefining the world of active investing. By utilizing investment strategies heretofore used only in the alternative arena, investment managers with the vision, skills, and infrastructure to implement this multidisciplinary investment process will be in a position to attract market share from both the active and passive segments of traditional managers.
Over the last two decades, a majority of active fixed income and equity managers have failed to beat their benchmarks. In the last ten years alone, the S&P 500 outperformed 85% of all Large-Cap Equity funds, and that lead widens to over 92% in the last five years. (See Exhibit 1 below) This index outperformance is even more substantial among fixed income funds where 96% of active long-maturity government bond-only funds were outperformed by the Barclays Long Government index over ten years and 98% were outperformed in the last five years. For Investment-Grade Long Funds even the best time frame for active funds (1 year) shows that 94% of funds were outperformed by the index, and for High Yield, that same time period shows 75% of funds underperformed their index.
Meanwhile, since the mid-90s, the hedge fund industry has grown rapidly, with AUM increasing by over $2 trillion. Institutional buyers of alternative strategies are generally looking to create a mixture of investment exposures that either diversify or leverage exposure to their traditional benchmarks. Historically, hedge fund investors have been pleased with the performance of their allocations but recently many notable managers have seen performance decline, causing some investors to question their allocation to the asset class.
Part of the recent disappointment comes from an identity crisis created by a lack of specific goals for alternative allocations. There is uncertainty around whether or not strategies are supposed to diversify risk away from traditional asset classes, or if they should provide higher performance than these traditional funds. Managers who have diversified their portfolios are often criticized for failing to beat the market, while those who have sought higher returns are then faulted for not being diversified and losing money when the markets fall. Again, clarity in the mandate is essential to understanding whether or not value is being delivered.
We see an opportunity for those alternative investment managers who can successfully create orthogonal, as opposed to leveraged, returns. These managers can integrate their strategies with those of more traditional investment approaches. This allows for active hybrid strategies which have both the market-based exposures pursued by traditional managers in combination with highly diversifying exposures generally reserved for alternative investments.
Data as of June 30, 2016.
Source: SPIVA Mid-Year 2016 (https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf?force_download=true)
Opportunity and Solution
One of the key opportunities available to those managers able to combine hedge fund strategies with more traditional asset management techniques is the vast difference in available investor dollars. Traditional investment mandates are much larger than alternative mandates: 85%-90% versus 10-15% of total portfolio allocations. Given the performance challenges faced by traditional managers and the fee pressure on hedge fund managers, traditional and hedge fund investment approaches are converging, thereby developing active hybrid products. Using hedge fund technology to extract uncorrelated return and long-only traditional techniques to achieve market exposure, better-performing products should evolve. As these products develop, clients stand to benefit from better performance within their traditional mandates and alternative asset managers stand to benefit from more available assets to manage. Given the skill set needed to implement alternative trading strategies and track records which speak to alpha capture, a select subset of alternative managers are well-positioned to design these products and compete for traditional asset management mandates.
The creation of such hybrid products will challenge the normal relationship between large allocators and hedge fund managers. The allocators will themselves become active managers and will think less about a hedge fund manager as one who manages a fund and more as someone who delivers specific types of risk and return exposures. Instead of gaining exposure to a fund, investors will aim to gain exposure to specific trading strategies, which can then be pieced together into a customized mandate.
In order to succeed, the hybrid investment approach must be similar in structure to institutional long-only mandates. Separate accounts for each client, rather than commingled funds, which have historically been the default structure for alternative approaches, will be the norm. Separate account structures allow for full ownership of the assets, thereby improving transparency of individual positions and associated risks. Such structures also give investors the ability to create specific performance benchmarks and/or return profiles for their hybrid portfolios to best suit their needs. For example, hybrid accounts could be benchmarked to beat specific equity, credit or duration indices, or alternatively could be established with the goal of creating an asymmetric return profile to provide enhanced diversification. These new account structures will help managers and investors better define investment goals, creating a more natural alignment of interests and assessment of success.
CASE STUDY: PAAMCO ACTIVE LDI
PAAMCO’s hybrid approach tackles an investment issue that has traditionally been solved using conventional long-only asset management and instead implements a solution that draws on our long experience in alternatives-based investing and applies it in an innovative way.
Pension investors following a Liability-Driven Investing (LDI) approach are struggling amid the extremely low yields currently on offer from high-grade corporate and sovereign bonds. At current levels of rates and spreads, and with strong demand for yield across the globe, traditional long-only asset management is finding it very difficult to extract alpha to add on top of the meager portfolio carry. This makes long-term expected returns look very unattractive and far lower than those experienced in the past.
For over four years, PAAMCO has managed an LDI solution designed to help solve this dilemma. While the target benchmark is a fixed income index, PAAMCO has implemented LDI such that, instead of being limited to credit selection in bonds, the portfolio can access a diversified set of non-directional return opportunities. This is coupled with an actively managed derivatives portfolio to achieve the required duration exposure. The PAAMCO Active LDI solution has the positive attributes of a bond portfolio when needed if interest rates continue to decline but mitigates the duration risk if rate rise and thus reduces the portfolio’s downside. This is made possible by the use of a much more diversified and opportunistic set of return engines which seek to generate excess return to augment low bond yields and fund the structures asymmetric profile. Using this in an LDI context helps minimize the long-term cost to the sponsor while still protecting beneficiaries.
Correctly pricing these hybrid investments is critical. Their pricing will naturally carry a higher management fee than a comparable traditional long-only account, as the strategy implementation is more complex. This may likely be augmented by a performance fee tied to the level of out-performance relative to the mandate. Aligning the interests of the asset manager and the investor to achieve excess return over the benchmark is somewhat novel within the traditional asset management world but is likely to become more common as investors seek higher returns and managers who can deliver will want to get compensated based upon successful performance.
The goal of this new hybrid approach is to provide better solutions for investors than are offered today. The combination of the hedge fund skill set with long-only risk exposure should allow for improved investment returns and diversification. If executed successfully, such an investment approach could reduce underfunded pension status, provide a reserve against unexpected liabilities, and can even allow for the creation of asymmetric return profiles.
Investors seeking innovative approaches to solve their return challenges should embrace this new active hybrid approach. It is a natural development following the low return environment of the past few years and helps in part to resolve the identity crisis surrounding alternative allocations of providing diversifying exposures or simply leveraged returns. Clearly there will be skeptics but also some early movers who are intrigued by the novelty of the approach and will want to be known as thought leaders among their peers.
Basil Williams is a Managing Director and Co-Head of Portfolio Management for the Fund of Hedge Funds Division. During his career, Basil has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, Basil spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980, and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.
Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.
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