Trends Watch: Funds of Hedge Funds

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Carl Friedrich, Managing Partner, Excelsior.

What is your outlook for alternative investments?

As stocks and bonds become increasingly passively managed (think index funds or ETFs), we see an evolving opportunity for hedge fund managers.  Simply put, each additional dollar of passive investment creates another dollar of opportunity for active management.  Furthermore, hedge funds are well positioned to exploit market opportunities from both buying and selling securities, as well as trading related securities less trafficked by larger investing audiences.  Combine this backdrop with meaningful market dislocation in all asset classes this year, and you have a recipe for hedge funds to potentially deliver incremental value relative to standard asset classes in the coming years.

Where do you see the greatest opportunities and why?

While hedge fund investments did an exceptional job of protecting downside in the most recent COVID-19 pandemic selloff, certain pockets of the bond market have become increasingly compelling: distressed debt and asset-backed securities.  Part of the recent selloff in these asset classes was driven by a lack of liquidity as certain highly leveraged funds sold assets at any available price to meet margin calls.  Looking more closely at the assets themselves, some of these securities are trading at values that presume certain default and/or little-to-no value recovery value.  As a fund of funds manager, we engage managers with decades of experience well equipped to navigate these opportunities, as well compelling track records in prior periods of dislocation.

What are the greatest challenges you face and why?

Our targeted client base primarily consists of independent wealth managers who have traditionally allocated portfolios to typical stocks and bonds.  With an extended bull market in both asset classes spanning over a decade, it can be challenging at times to focus their attention on alternative asset classes.  This year’s market environment has demonstrated the need for legitimately differentiated asset classes.  Especially when acknowledging that interest rates in the U.S. have never been closer to zero, the interest rate risks to even conservatively allocated bond funds could present a headwind to bond returns.  This opens the door to considering less rate-sensitive opportunities like those traded by our hedge fund portfolios.

What keeps you up at night?

Most of the hedge funds in which we invest attempt to offset as much market risk in their portfolios as possible – this puts the “hedge” in “hedge fund.”  That said, there are opportunities – such as those seen in the distressed debt markets over the first half of 2020 – where valuations are so deeply suppressed, that opportunities are compelling even if the hedging options are scarce or ineffective.  Thus, as we have seen a number of managers scoop up deeply discounted bonds and loans, in order to participate in the potential for meaningful upside, we need to be comfortable enduring the risk that these positions could lose value in a subsequent downturn.  Given how generously the markets rewarded such investments in prior crisis periods, we are willing to endure some of this risk in the portfolio – but we’ll certainly sleep better when and if these positions appreciate to a level where they can be sold.

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.