Fund of hedge funds firm Hilltop Fund Management says it is important for fund of hedge fund managers to tell investors whether they are producing hedged or absolute returns.
Hedging is a way of managing risk by using an investment in one market or asset class to offset against moves in another. To do this, managers try to predict what strategies will do well over the short term and build their portfolios around these views. This is different to the absolute return approach, where managers create a portfolio of uncorrelated hedge funds to produce positive returns in all market conditions.
Hilltop says the distinction between the two terms has become blurred in recent years, with the hedge fund industry becoming known as the absolute return industry. Hilltop believes this is wrong and that understanding the difference is vital to determine how hedge fund investments fit into an investor’s portfolio.
Hilltop founding partner and portfolio manager Rory Hills says many mainstream funds of hedge funds are highly correlated due to a flawed investment process that failed investors in recent financial crisis.
He believes rapid growth in assets that funds of hedge funds enjoyed between 2003 and 2005 brought about this flawed process.
Some managers changed their business models to win mandates from pension funds and private banks that were used to dealing with big institutions.
This evolved into a box-ticking approach that Hills thinks has become the norm for many funds of hedge funds. He says this approach often rules out good managers for non-investment reasons and relies too heavily on junior analysts who do not have enough experience to assess hedge fund managers.
Hills says: “The hedge fund industry has become known as the absolute return industry but that is not right. We think it is important to tell investors which one you are, as hedged products will be correlated. At Hilltop we focus on absolute returns by looking for good managers who are uncorrelated.”