Hedge Funds Are About To Boom

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• Hedge funds are set to benefit from a radically altered environment where the winners will be those who offer the broadest suite of opportunities and tools for active portfolio management.
• Diversification is the name of the game, according to Mercer Investment partner and head researcher John Jackson.
• Constructing portfolios is more art than science but comes with a framework: Identify talent and select managers first, then allocate with multi-strategy, security selection and diversification.

Think about the last time shortcuts beat hard work.

Those who answer with “never” will find themselves in good company with John Jackson, partner and head of hedge fund research at Mercer Investment Consulting. As manager of more than 20 hedge fund research analysts, John oversees more than $10 billion in global assets.

“I've tried every shortcut,” the industry veteran says in conversation with Alan Dunne. “None of them have really worked. And when it comes to hedge fund investing, you have to do the work. Otherwise, there are going to be surprises along the way and they might be uncomfortable.”

And if you’re doing the work, the upside can be significant. John thinks that hedge funds are about to bounce back from a dreary global financial crisis (GFC) and COVID-ridden state. If that seems like a bold prediction, consider the source. Of the 23 years John has spent in financial services, 16 have been dedicated to hedge funds.

“It’s been a little bit of luck and happenstance,” he says. After graduating in economics at the turn of the century and dabbling in advisory, he quickly found his calling in research based in a firm in St. Louis. After Mercer acquired his outfit, he angled his way into the realm of hedge funds, and the rest, as they say, was history.

In an uncertain and ever-changing financial landscape, John is the go-to voice of reason for how to allocate capital and select fund managers.

Here are some of his standout views.

The hedge fund universe is shifting

The world has experienced quite a change in the macro environment, with 2022 a watershed year heralding giddy anticipation for hedge funds.

“Hedge funds play a critical role within a portfolio,” John says. “It's a strategic — not necessarily a dynamic or tactical — allocation, but now more than ever, we're convinced this is a different environment.”

Compare the current rate rises and associated capital costs with the previous decade: “Central bank policy coming out of the GFC really left no room for any alternative than to own beta — you were penalized for any sort of diversification,” John explains. “The opposite is true now.”

That means both macro and micro level volatility and dispersion, which was lacking in the post-GFC to 2019 period, at which point COVID kicked in. “That bodes well for active management,” John says. “We think hedge funds offer the broadest suite of opportunities and tools as it relates to active management.” This performance from 2022 to date can be seen on both sides of the portfolio — long and short.

For this reason, John highlights, “most hedge fund strategies are going to do better in a higher rate environment,” thanks also to its structural benefits and associated tailwinds.

Diversification backed by flexibility and risk-reduction

How can hedge funds take advantage of this favorable environment?

“You need to build a diversified program across all of those underlying strategies,” John says. “Hedge funds offer some of the strongest diversification benefits — both traditional and alternative — and play quite a unique role in the portfolio.”

But building a hedge fund allocation from scratch is no easy feat.

Mercer level-sets with education and understanding the objectives of hedge fund allocation. “Part of the beauty of hedge funds is flexibility,” John says. “You can almost position them in any way that you want within a portfolio.” Their primary function? Risk-reducers. “What is the risk that dominates the rest of the portfolio?” John asks. “By and large, equity and interest rate risks.”

When it comes to portfolio construction, there are two key facets.

Portfolio construction element #1: Manager selection

For portfolio construction, it's “critical to start with manager selection,” John says. Rather than establishing the buckets to fill and then finding the managers to fill them, focus on talent first: Where is it and how can it best be utilized to achieve the objectives for which the business is aiming?

“You have to be open-minded to find really good, talented managers that have a skill set and niche that they can consistently execute on with some persistence and add value to the portfolio,” John highlights.

Avoid filling buckets before anything else. Initially, identify talent, build teams, and put them on the field to execute what they need to execute. Then, establish asset categories.

Portfolio construction element #2: broad buckets

Once the talent is locked in, it’s not a case of pinning the tail on the donkey — there’s method to the apparent madness. Mercer identifies three broad categories for hedge fund allocation:

1. Multi-strategy: serves as a base and the core of the portfolio, providing a consistent, all-weather return stream to the hedge fund allocation
2. Security selection: return-drivers enhanced via specialists and broken into sub-categories, including long-short equity and long-short credit
3. Diversifying strategies: both the hedge fund and broader portfolio, including discretionary and systematic macro, long volatility and tail strategies for added convexity

This process is “more art than science for us,” John says. Optimizations sometimes offer a “false sense of security.” While they’re a good “sanity check, it's more about the fundamental building blocks and really knowing what you own and understanding each individual manager, their style, their process, and how they'll fit into a portfolio.” John is confident that Mercer can achieve its objectives without a large-scale optimization process.

Avoiding leveraging issues, crowding, and waves of degrowth

To mitigate struggles within hedge funds, due diligence is critical along with forecasting game plans for different scenarios when selecting managers.

“The war for talent is ever increasing,” John explains. High turnover among the top firms reveals a continuous talent trade, and these managers “get used to return streams as long as they can, then when they hit a drawdown, just find another home.”

“The concern for us is getting our arms around due diligence,” John highlights. “The amount of leverage deployed, crowding in the space and growth is significant.”

The key is to “understand what you own and how to manage risk in different periods,” John says. Track records can offer valuable insight, but newer and emerging managers don’t always have these. “You really have to roll up your sleeves and get to know their process, how they think about risk management and how they'll react under pressure.”

Mercer also considers the asymmetry balance managers bring to the mix. “We protect on the downside first and foremost but also participate on the upside as much as we can,” John says.

Picking talent

How should businesses select the right managers?

“We try to be as unbiased and open in terms of sourcing as we can,” John says of Mercer’s talent-hunting efforts. “We don't have any kind of requirements or restrictions — we will really look at anything and everything.” John admits that Mercer does have some bias, but “we’re willing to violate all of them in the pursuit of something exceptional.”

To this end, “the top of the funnel is really as wide as we can possibly get it,” he says. More important is the filtering process that follows:

1. Lists of recommended managers should include a consistent, repeatable framework making it harder to be filtered through than being initially looked at
2. Introductory meetings with lead research committees dedicated to certain strategies — macro, equity, credit, and managed futures — manage the opportunity pipeline
3. Discussion and debate on interesting opportunities may lead to moving forward with deeper due diligence
4. The cream organically rises to the top when Mercer identifies and brings in top talent in a common sense fashion: “Who does it make sense for us to partner with on behalf of our clients?” John asks

It comes down to a broader mandate. “We're looking for managers that can be adaptable and flexible who tilt to wherever the opportunities might be,” John highlights. Niche, narrow mandates exist for Mercer, but there’s a higher bar.

At that point, it’s about identifying managers’ risk management processes and how they deal with difficult periods. “That's where hedge funds outshine,” John says. It’s one part proactivity and taking down risk, and another part taking risk back up and capitalizing on opportunities.

“It really comes down to learning their process as deeply and intimately as we possibly can,” John emphasizes.

The benefits of research committees in decision-making

It’s not just a diversified portfolio that matters to Mercer: The firm also strongly values the “diversity of thought and inputs” of its selection committees, John explains. The mix combines different geographies, ages, and experience, and “on balance, that adds to a more robust process.”

“Everyone has a voice — it's free and open,” he says. “Anyone can bring anything that they think is compelling forward.” This cross-team autonomy leads to asking whether it fits with what Mercer needs. “Is it additive to what we already have, does it complement or is it an upgrade?” John asks. It’s an ensuring process backed by an initial due diligence framework that holds everyone on the team accountable — on every single opportunity. John admits that it can be slow, but emphasizes how healthy it is. “We're looking at these manager allocations for a five to 10-year period,” he says. “I don't necessarily think the best decisions are always rushed.”

“The committee structure has more benefits than it does drawbacks,” John highlights.

Assessing managers via strategies

Mercer doesn’t just rely on committees for selection, but also deeply understanding the processes of the managers the firm has selected. Clarifying the inefficiencies on which these managers are trying to capitalize is one thing — backing it up with results and a proven track record is quite another.

For ongoing assessment, if Mercer has understood how robust managers’ models and systems are from the outset, they should deliver over the long term. “But it does come down to the people as well,” John says. “We want to understand their R&D process and how much they’re looking to improve the system.”

“This isn't a space where you can rest on your past work: you have to evolve and progress. It's a competitive space.” Managers have expanded the number of markets in the last few years by looking at alternative systems and data to diversify and offset shortcomings of trends with varying degrees of success.

“It’s a tricky area,” John says. “There are ways to screw up robust systems pretty quickly by tinkering with them too much.”

TransformAItional?

At the same time, just how robust systems can get will be a big concern for those working with AI.

In the quant space, AI seems to be making a loud splash. But John is more sober: “Machine learning has been around for two decades: for the leaders in the space, AI is a significant change, but still a step change.” It’s early days, far from completely autonomous systems that decide on the best strategies to implement.

But for those that are pioneering AI use, Mercer prioritizes guardrails, minimum expectations, and risk exposure. “In the quant space, transparency is somewhat limited,” John says, which can present a challenge. “We would have to at least understand the bounds or range of what the system might be doing.”

Don’t ever shortcut learning

It’s one thing for machines to be learning, but even humans have a long way to go. And if the hedge fund universe has anything to teach, John wants to learn it.

John’s key advice for solid performance is as applicable to life as the hedge fund space: “Don't look for shortcuts.” Doing so could cause trip-ups and nasty surprises. There’s no real substitute for hard work, and anyone who wants to operate well in the hedge fund space needs to take the time to learn it. “It's nuanced — there's a lot to learn,” he says. There’s so much to learn that sometimes surprises come along. “Even though you might have heard the same pitch 10 times — you'll hear the 11th one and you're like, Wow, this is really special and unique. And, you know, I kind of want to go along for the ride here.”

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.