One of the difficult parts of operating as an institutional investor is choosing a roster of external managers. It’s particularly hard if your institution hasn’t clearly established the purpose of using a given investment strategy in the first place.

Let’s consider hedge funds. One prominent U.S. hedge fund in particular achieved net returns of 3.7 per cent over the five years ending December 31, 2018, compared to an S&P 500 return of 8.5 per cent. On the surface, it would seem reasonable to be unsatisfied with the situation, the hedge fund is relatively expensive and the S&P 500 could have been accessed passively for a mere few basis points in annual fees.

However, when considering whether to divest from this hedge fund, it would be key for an investor to understand why they held it in the first place.  Turning over external managers is a costly process, estimated to be in excess of one per cent of assets turned over in some cases. As such, it’s crucial to not only understand the strategy one is undertaking but also to set appropriate goals, benchmarks and expectations with respect to it.

The above-noted hedge fund lagged the S&P 500 significantly over the reference period.  Importantly, however, it had effectively zero correlation to U.S. equities and U.S. fixed income and a 14.6 per cent return for calendar 2018, a year which featured middling to terrible returns in these asset classes. Even at higher fees, purely uncorrelated return streams are extremely valuable in the context of portfolio construction.

The fund referenced above is a global macro hedge fund—one of 34 hedge fund styles that global index provider Hedge Fund Research Inc. recognizes. This underscores an important point: hedge funds aren’t an asset class. They’re generally characterized by their unconstrained nature, the use of leverage, unique legal structures (general partner-limited partner relationship often with an offshore component) and fees significantly in excess of widely accessible public equity and fixed income strategies. Beyond this, their strategies are far from uniform, which has significant implications for performance appraisal and due diligence.

Benchmarking hedge funds is an inexact exercise but, generally speaking, best practices include comparing hedge funds from within the same style and vintage year to the extent possible and using risk-adjusted metrics. Comparability between the different strategies and vintages is generally very poor as they’re affected by significantly different external forces and are managed using completely different approaches.

Hedge funds have succeeded in achieving significantly lower risk than public equities over most time periods. Many hedge funds seek explicit volatility targets and enhanced downside protection, and they have, by and large, been successful in delivering on this effort.

The Sharpe ratio and information ratio are two widely used tools to assess performance on a risk-adjusted basis. The Sharpe ratio helps assess risk-adjusted returns in excess of a risk-free asset, whereas the information ratio helps assess these returns in excess of some other benchmark, such as a public equity benchmark (though this selection would depend on the strategy). Using these metrics alone wouldn’t satisfy the due diligence requirements when assessing hedge fund strategies but are a reasonable place to start.

Overall, the appraisal of hedge funds should seek to assess the consistency of previous return streams while ascertaining whether these results are likely to continue based on an assessment of the manager and their process. Incorporating these assessed return streams into the portfolio optimization process will help determine whether a hedge fund strategy has a place in an institution’s mandate.

Recently, hedge funds as a whole have provided weak returns relative to public markets, particularly in the U.S. where simple passive all-stock and balanced portfolios have enjoyed a period of magnificent returns. This shows in investor sentiment as well. For example, BlackRock Inc.’s 2019 global institutional rebalancing survey indicates that, on a net basis, global institutions intend to reduce hedge-fund allocations, while massively favouring increased allocations to private equity and real assets. As well, the number of hedge funds globally plateaued in 2017 at 15,828, according to Preqin Ltd. Many players in the space have been forced to cut fees due to pressure from their investors — Hedge Fund Research noted in mid-2018 that only 30 per cent of hedge funds were still operating under the two and 20 compensation arrangement (two per cent management fee and 20 per cent of profits) that was once a staple in the industry. Though it was difficult to endorse the idea that the majority of hedge funds would provide returns high enough to justify a two and 20 fee arrangement, we may be entering a period where the opportunistic institution may benefit from an increased hedge fund allocation.

As is the case with traditional investment vehicles, hedge fund return patterns are likely to ebb and flow, with periods of sustained poor performance and investor dissatisfaction often mean reverting to more favourable levels after a period of time. This, alongside rapidly falling fees and a less crowded hedge fund industry, may lead an institution to move against the tide and consider hedge funds in executing their mandates.