Despite their complexity, hedge funds can play a role in pension portfolios—but you need to know what type you’re dealing with. When it comes to their strategies and performance objectives, hedge funds fall into three broad groups.

1. Contaminants. This group gives hedge funds a bad name. Contaminants—a qualification I’ve given them because of their impact on markets—apply leverage to a portfolio and short an index. They go long on illiquid stocks and short on liquid stocks. When the market is generous, they harvest the illiquidity premium and do well. But when the market crashes and there’s a thirst for liquidity, the illiquid stocks of these hedge funds depreciate. The funds are then forced to liquidate the illiquid stocks, causing them to blow up and contaminate the market. From an institutional investor’s perspective, it’s best to avoid this type of hedge fund.

2. Alpha-focused funds. With their sophisticated tool box, alpha-focused hedge funds offer access to unique risk and return factors unavailable in the traditional asset space, including the debt of bankrupt entities or those close to bankruptcy. They also include merger arbitrage, where a hedge fund simultaneously buys and sells the stocks of two merging companies to make a profit. (The hedge fund sells the stock of the acquiring company and buys the stock of the target company because when the merger deal closes on time, the new company’s stock price goes up, compared with the stock price of the acquiring company.)

These factors are bundled within an effective risk mitigation framework to suppress the impact of unwanted risks. Unlike contaminant hedge funds, alpha-focused funds aim to generate returns (alpha) from both the long and short sides of the portfolio. Managers tend to outperform markets in good times and lose less than the market in bad times. Investors benefit from good returns with reduced volatility.

The downside of alpha-focused hedge funds is, in market crises, they will soften the blow but can still have negative returns. That’s because they offer risk mitigation, not risk management.

3. Absolute return funds. These represent a unique and much smaller share of the hedge fund universe. They tend to be deployed along the most liquid spectrum of tradeable securities, with active risk management. Portfolio inclusion and position sizing depend on how the market reacts to the manager’s assumptions about certain opportunities. Many managers will find an undervalued investment, and then, as the market starts moving and confirms their opinion about the valuation, they will fully express their view by allocating more portfolio capital to that opportunity.

With these hedge funds, managers shouldn’t dwell too much on risk mitigation or they won’t be able to deliver absolute returns. Also, to get absolute returns, managers must avoid overconfidence about the value of the investment opportunities they’ve picked and the tendency to sell appreciating stocks too soon while keeping depreciating ones for too long.

What EXACTLY are hedge funds?

> Funds using sophisticated investment strategies such as leveraged, long, short and derivative positions to generate high returns

> Often illiquid investments set up as private partnerships

> Used mainly by institutional or high-net worth investors

Source: Investopedia

These hedge funds do well in bull or bear markets, during volatility spikes and when there’s a post-crash scramble for liquidity. While these funds outperform in down markets, they tend to underperform in aggressive bull markets.

And remember: you can’t have absolute return and alpha-focused strategies in a single hedge fund because they’re mutually exclusive.

While pension funds should avoid contaminant hedge funds, they should consider investing in the other two types. These funds can offer attractive and de-correlated returns—particularly useful in downturns when the rest of the portfolio is suffering.

Rene Levesque is founder of and an analyst with Mountjoy Capital.

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Copyright © 2021 Transcontinental Media G.P. This article first appeared in Benefits Canada.

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