In the world of portfolio construction, achieving superior returns often resembles a delicate balancing act – much like seasoning a well-prepared meal. Core ingredients such as equities and bonds provide structure, but without thoughtful enhancement, the end result can feel underwhelming.
Hedge funds, when used as a source of portable alpha, can serve as that critical finishing touch – enhancing returns without fundamentally altering the underlying portfolio.
For financial advisors navigating today’s low-return and uncertain environment, this approach offers a compelling way to improve outcomes while maintaining diversification and risk discipline.
Portable alpha: Enhancing without disrupting
Portable alpha refers to the separation of ‘alpha’ (skill-based excess returns) from ‘beta’ (market-driven returns).
This concept, pioneered by investment management firm PIMCO, allows investors to generate returns independently of traditional market exposure and apply them across a chosen portfolio structure.
In practice, this means advisors can retain efficient market exposure through traditional assets, while overlaying alpha strategies – such as hedge funds – to enhance total returns.
The result is a more flexible and resilient portfolio, particularly valuable in environments where market returns may be muted.
Building the foundation: Sourcing beta efficiently
A well-constructed portfolio begins with reliable beta exposure, typically sourced through a blend of passive and active strategies.
Passive investments, such as index funds and exchange-traded funds (ETFs), provide efficient and transparent access to global markets.
For example, funds tracking the MSCI World ETFs often carry total expense ratios of 0.05%-0.06%. Locally, ETFs tracking the JSE Capped SWIX Index typically have expense ratios of around 0.30%, according to 1nvest disclosures.
These strategies form a cost-effective backbone, allowing portfolios to capture market returns with minimal friction. Active managers can complement passive exposures by introducing modest tactical adjustments while remaining closely aligned to benchmarks.
Research by Martijn Cremers and Antti Petajisto introduces the concept of active share, showing that many actively managed funds exhibit low deviation from their benchmarks.
A significant proportion of funds – often referred to as ‘closet indexers’ – closely replicate benchmark holdings while maintaining an active management structure. This highlights their continued role as beta providers with limited but targeted flexibility to navigate market conditions.
Blending passive and active strategies can therefore create a diversified and efficient beta foundation.
Introducing alpha: The role of hedge funds
With beta exposures in place, hedge funds can be introduced as dedicated alpha generators.
Unlike traditional long-only strategies, hedge funds are not constrained by benchmarks and can employ a broader toolkit – including short positions, derivatives, and leverage – to target returns across different market environments.
Research and industry insights from institutions such as the CFA Institute and AQR Capital Management highlight their ability to deliver returns with lower correlation to traditional asset classes.
This makes them particularly effective within a portable alpha framework, where their return streams can be layered onto existing beta exposures.
A structured approach
Incorporating hedge funds into a portfolio requires a disciplined and structured process:
- Assess objectives: Define client risk tolerance, return targets, and time horizon.
- Select managers: Focus on consistency, risk management, and drawdown control.
- Integrate strategically: Allocate to hedge funds as an alpha ‘overlay’ alongside core holdings.
- Monitor continuously: Review performance, correlations, and evolving market conditions.
This ensures that hedge fund allocations enhance, rather than disrupt, the overall portfolio.
The outcome: A more resilient portfolio
When implemented effectively, a portable alpha strategy can offer several key benefits:
- Enhanced returns: Additional alpha can improve total portfolio performance.
- Downside protection: Many hedge fund strategies incorporate risk-mitigation techniques.
- Diversification: Low correlation to traditional assets can reduce overall volatility.
- Flexibility: Alpha can be applied without altering core asset allocation.
In an environment where passive investing continues to grow – now exceeding $13 trillion globally in equity assets, according to Morningstar – the ability to complement beta with differentiated alpha sources is increasingly valuable.
Disclaimer:
The information contained herein is provided for general informational and educational purposes only and does not constitute financial, investment, tax, or legal advice as contemplated in the Financial Advisory and Intermediary Services (Fais) Act. All ideas, comparisons, strategies, and examples presented are general in nature and should not be construed as a recommendation or solicitation to buy, sell, or hold any financial product or to adopt any specific investment strategy. Past performance is not necessarily indicative of future results. Hedge funds and alternative investments involve risks, including potential loss of capital, illiquidity, and the use of leverage and derivatives. The value of investments may go down as well as up. Investors and financial advisors should consider their own individual circumstances, objectives, financial situation, and risk tolerance before making any investment decision and should seek independent professional advice where appropriate. Peregrine Capital (Pty) Ltd accepts no liability for any loss or damage arising from reliance on the information presented in this article.
For more information, visit www.peregrine.co.za.
Waldo Booysens is an investment specialist at Peregrine Capital.
Moneyweb does not endorse any product or services being advertised in sponsored article on our platform.