The Art and Science of Hedge Fund Portfolio Construction

Constructing a hedge fund portfolio involves a delicate balance between art and science, blending qualitative insights with quantitative rigor to achieve a resilient and high-performing overall investment strategy. Hedge fund portfolio construction is a process that requires a deep understanding of market dynamics, risk management, and strategic allocation of assets. Below, we explore the key elements of this process, drawing from contemporary best-in-class investment practices.

Investment Philosophy and Strategic Allocation

The foundation of any hedge fund portfolio is its investment philosophy, which guides the overall approach to portfolio construction.

One approach is to come up with top-down target weights for style buckets and strategies that reflect the weights of these strategies in a hedge fund index or the industry’s AuM levels. However, this approach ignores the risk-return characteristics of the individual styles, optimal approaches of how to combine them, as well as the availability of high-quality managers within each style or strategy bucket.

A better approach in our view is to start with a bottom-up qualitative as well as quantitative analysis of each style bucket and strategy and allocate only to a selected subset of styles and strategies in a manner that is appropriate for a mandate’s goals (e.g. target risk and return, market beta, liquidity requirements, investment size, etc.). For example, the Convergence (includes Market Neutral and Relative Value strategies) style offers higher consistency of returns and low correlation to other managers or market factors, but it has a higher exposure to tail risks due to e.g. its higher leverage. The Long Biased styles (includes Equity Hedge and Event Driven) offer a more linear relationship between market and strategy performance, but they have a lower Sharpe ratio and a higher beta exposure. The Divergence style (includes discretionary and systematic Global Macro strategies) has an even lower expected Sharpe ratio on average, but offers the ability to benefit from market dislocation events.

Combining the three styles and assigning them allocation targets and bands after a bottom-up analysis of the style characteristics, but also of the available high-quality hedge fund managers, is as much an art as science. Additional characteristics of the implementation also play a role.

For instance, within the Convergence style one can select single strategy funds or concentrate on multi-strategy platforms. Due to the low correlation among Convergence strategies, an allocation to a multitude of portfolio managers is desirable and multi-PM funds allow for an easy solution of this objective.

The inherent beta of the Long Biased style means that an allocation to it may additionally benefit from alternative premia that comes with the beta, such as event alpha or complexity and illiquidity premia.

Within Divergence, one category that is broadly represented is the one of trend-following managers, which tend to be relatively highly correlated, so the number of managers allocated to them needs not be high. Besides relying on convexity, Divergence managers may also benefit from market dislocations if their strategies are inherently long volatility, which is a rare, but desirable portfolio construction characteristic of some Global Macro managers. Thus the Divergence allocation, if implemented correctly and in the right size may act as a portfolio stabilizer during market or economic downturns.

Quality and Conviction

A cornerstone of hedge fund portfolio construction is the assessment of quality and conviction in the available managers and strategies. Quality is determined by factors such as the length and quality of a manager’s track record, the stability of their organizational setup, the firm’s competitive advantages, team pedigree, and the robustness of their risk management processes.

Ideally, the allocation to managers is proportionate to their quality (e.g. as expressed by a hedge fund rating) and inversely proportional to the managers’ correlation, volatility or drawdown risks. All this is optimized within the above determined target style allocations and allocation bands in a feedback process.

These manager allocations may be magnified or reduced by the analyst’s current conviction in the respective managers, which is often based on the strategy’s expected opportunity set, manager outlook, recent events, strategy or manager restructuring and optimization, changes in the management or trading teams etc.

Capacity and Liquidity Management

Managing capacity and liquidity is critical in hedge fund portfolio construction.

Capacity refers to the ability of a hedge fund strategy to manage additional capital without negatively impacting performance. Portfolio managers must assess the capacity of each strategy and ensure that investments are made within those limits to avoid diluting return. Reserving capacity with managers for future allocations is also an important aspect.

Liquidity management involves balancing the portfolio’s need for liquidity with the higher returns often associated with less liquid assets and the investor’s liquidity requirements. This calls for careful planning, including setting portfolio liquidity terms and cash projections to ensure that the portfolio can meet redemption requests and other cash needs without being forced to sell assets at unfavorable prices​.

Risk Management and Quantitative Measures

Effective risk management is integral to hedge fund portfolio construction. This includes both qualitative assessments, such as identifying unattractive risks to avoid, and quantitative measures, such as continuously calculating portfolio beta, stress testing, and maximum drawdown analysis​. Quantitative risk measures help in understanding the potential impact of various market scenarios on the portfolio and in setting appropriate risk limits.

The portfolio’s overall risk profile should be aligned with the investment objectives, and regular monitoring is required to ensure that it remains within the desired parameters. This might involve adjusting the portfolio’s exposure to different strategies or sectors in response to changes in market conditions or the performance of individual funds.

Ensuring that each investment fits well within the overall portfolio is crucial. This involves assessing how each fund contributes to the portfolio’s risk and return profile, particularly in terms of its marginal risk contribution to correlation, volatility, market beta, style factor exposures, illiquidity etc. The goal is to construct a portfolio where the combined effect of all investments results in a balanced and diversified risk profile that aligns with the investor’s objectives.

Style Buckets and Tactical Tilts

Allocating assets across different style bucket such as Convergence, Divergence, and Long Biased is another key aspect of portfolio construction. Each style bucket represents a different risk-return profile as discussed already, and the allocation to each bucket should reflect the portfolio’s overall strategy and market outlook.

Tactical tilts are adjustments made to the strategic allocations (within the bands defined above) in response to short-term market opportunities or risks. For example, during expected periods of market stress, the portfolio might increase its allocation to Divergence strategies, which are designed to perform well in volatile environments​. Conversely, after a severe bear market, an increased allocation to Long Biased strategies may lead to outperformance. These adjustments are typically based on a combination of qualitative insights and quantitative analysis, ensuring that they are well-supported by data, macroeconomic analysis and market trends​.

Top-down views and tilts should be made with care and predominantly aim to avoid amassed excessive risk concentrations (as indicated by e.g. quantitative tools indicating expected drawdowns in stress test or scenario analyses) or unattractive risks exposures (e.g. structured credit in early 2008), as market timing is notoriously difficult.

Concentration and Number of Funds

Setting concentration limits is a common practice to avoid an impact from a single manager to impact the overall portfolio too heavily.

On the other hand, overdiversification is a common pitfall in hedge fund portfolio construction that can dilute returns and increase complexity without necessarily improving correlation or loss risk. Academic and practitioners’ studies show that most diversification benefits are exhausted in a portfolio of 12-15 hedge funds. While diversification is essential to mitigate risk, excessive diversification can lead to a portfolio that is difficult to manage, less efficient, and ultimately underperforms relative to a more concentrated approach.

To avoid the pitfalls of overdiversification, hedge fund portfolio managers should aim for strategic concentration. This involves focusing on a smaller number of high-conviction investments that offer the best potential for higher absolute risk-adjusted returns, while making the portfolio easier to manage, improve decision-making and responsiveness to new information or changing market conditions. With fewer investments, it is also easier to understand and manage the specific risks associated with each strategy.

Higher selectiveness when choosing managers allows to focus on a smaller number of managers who excel in their specific domains. Still, each selected strategy should bring something unique to the portfolio, whether it is uncorrelated returns, differentiated risk management, or a distinct market opportunity. A well-balanced portfolio allows for robust performance and attractive returns in most market scenarios.

Performance Monitoring and Rebalancing

Continuous monitoring of the portfolio’s performance is essential to ensure that it remains aligned with the investment objectives. This includes tracking both absolute and risk-adjusted returns, risk metrics, as well as monitoring for style drift and other potential risks.

Rebalancing is an ongoing process that involves adjusting the portfolio’s allocations to maintain the desired risk-return profile. This might involve reducing exposure to outperforming strategies to lock in gains, or increasing exposure to underperforming strategies that still have strong fundamentals and potential for future growth. An alternative may be to let winners run, which also means fewer transactions and thus potentially lower opportunity costs. Both aspects have their merits and a combination of both (after predetermined thresholds are reached) seems beneficial.

Conclusion

The art and science of constructing a hedge fund portfolio involves a meticulous process of selecting high-quality managers, managing capacity and liquidity, and implementing rigorous risk management practices. By focusing on key aspects such as style allocation, portfolio fit, and macro outlook, portfolio managers can create hedge fund portfolios that are both resilient and capable of generating attractive returns across different market environments. The integration of both qualitative insights and quantitative analysis is crucial in achieving a balanced and effective portfolio, ensuring that it meets the long-term objectives of the investor.

Resonanz Capital works with the best hedge fund professionals available. We have a proven track record of successfully handling complex strategies. Our experienced hedge fund management process has produced substantial capital gains with low market dependence, while outperforming peers.

Contact us today, as we guide you towards generating value through hedge fund investments.