Capturing Unexpected Winners

For two decades I worked with the largest, most sophisticated investors in the world who had access to any investment strategy. When it came to how they managed their alternatives portfolios one thing stuck out to me as different from how many investors think - they typically invested in dozens of managers for each category. Future Fund of Australia recently highlighted investments in 24 managers in their 14% allocation to alternatives. With so many managers, they were effectively building an index exposure to hedge funds and with it nearly always captured the best performing strategies in a given year.

Picking which hedge fund strategies and which managers will outperform is a difficult task which is why most sophisticated funds are taking this index approach. The table below shows the annual returns for each major sub-strategy in the Credit Suisse Broad Hedge Fund Index. While all strategies add value over time, there isn’t an obvious pattern to which perform better or worse in any given year. Take managed futures - after years in the doghouse, the performance in the first quarter was one of the best in history. Long/short equity underperformed after years of leading the asset class. It would have been hard to perceive this shift in enough time to benefit.

This year is a lesson for investors that diversifying alpha returns captures the unexpected winners. While most investors can’t create sovereign wealth fund style portfolios, all investors can strive for manager diversification that moves toward indexation. It’s the only reliable way to improve odds of capturing the next outperforming strategy.