In the ever-elusive search for diversification that doesn’t sacrifice liquidity, UK defined contribution plans are increasingly seeking out liquid alternative solutions. With investment costs as a key battle ground, the emphasis for DC plans is on how to find liquid, cost efficient sources of return that are less correlated to public markets without breaking the bank on fees.
Liquidity requirements for DC plans have long hampered their incorporation of certain alternatives, even though the decades-long time horizon of many savers make such investments a sensible fit. For example, alternatives have perhaps historically shown up only in small exposures within diversified growth funds, but innovations in daily pricing on non-traditional investments are changing the investment opportunity set.
At the same time, hedge fund investing is currently undergoing a fairly seismic transition. The quant revolution has given rise to the gradual democratisation of hedge fund investing, powered by more sophisticated technology and more importantly a better understanding of the sources of economic return. Investors have woken up to paying alpha-level hedge fund fees for beta performance, and that genie is not going back in the bottle.
The hedge fund electronic jungle has a few graveyards, so it’s worth DC trustees and scheme managers spending some time on the history to better understand the future and to better consider how liquid alternative hedge fund strategies can add value to their default funds.
Years ago, early and ill-informed attempts at so-called top down hedge fund replication scarred a generation of investors. Today, that first wave of mostly failed products tends to colour the perception of so-called hedge fund ‘replicators,’ but the reality is much more nuanced.
In the early 2000s a number of investment banks seized on the opportunity to create synthetic hedge fund replicators. This arms race to launch product was in part driven by the embrace of academic research that separated ‘beta’ and ‘alpha,’ chipping away at the once conventional wisdom that hedge funds were the domain of purely idiosyncratic alpha. The early stage concepts were onto the right idea, but focused on top down replication which resulted in a backward looking portfolio that was typically made up of traditional beta such as exposure to the S&P 500, a High Yield index and duration.
In other words, this first raft of products weren’t really trying to do what hedge funds did, but instead were looking to produce similar patterns of return. They basically took an index like Hedge Fund Research Index (HFRI), applied regression analysis to deconstruct the returns into liquid factors and then bought them up. The strategies were simplistic and typically carried a high correlation to equities. Most were disappointing and eventually shut down.
It is important for DC plans to understand that today’s liquid alternative funds are a different breed. In the wake of that first wave having petered out, strategies got a lot more sophisticated. They also underwent an important sea change, shifting from top-down replication to a much more holistic, bottom-up approach. The underpinning investment philosophy is today centred on the ability to harvest significant portions of hedge fund returns more efficiently.
Academic analysis demonstrated that much of what was once considered ‘alpha’ in hedge funds is actually a type of ‘beta’. These developments lead to efficient means of capturing hedge fund beta systematically with straightforward, rules-based processes. These so-called alternative beta strategies, or alternative risk premia strategies, are all about understanding that systematic exposure to premiums may have as much to do with returns as pure human talent. Building hedge fund exposures with a bottom-up approach provides broader diversification with low correlation to traditional assets.
This movement towards lower fee, more transparent and more accessible sources of hedge fund-like returns is a good thing for all investors, but particularly so for DC plans. They can provide a much-needed source of non-traditional asset class returns, enhancing portfolio construction and improving investment outcomes, without presenting an illiquidity hurdle.
Relative to our DB brethren, DC plans have a real opportunity to deliver more risk-efficient default funds using a broader palette of alternatives. The proliferation of liquid alternatives strategies able to deliver the characteristics of hedge funds with transparency and daily pricing open up a number of advantages that DC plans can’t afford to ignore.
