Investment Insights Series
Uncorrelated alternatives: Multi Strategy
1Q20
In an environment where, increasingly, risk and risk-free assets are rising or falling in concert based on government and central bank monetary policies, well-diversified Multi Strategy portfolios may be uniquely positioned to provide a hedge against tail risk when stocks and bonds together witness sharp falls.

Overview
For most institutional investors across Europe, the Middle East and Africa, 2019 was a very good year. Persistent strong performance across most asset classes meant that global equities and bonds continued their post Global Financial Crisis (GFC) decade-long bull run. This happened despite a backdrop last year of low interest rates and geopolitical uncertainties with, inter alia, the US-China trade war and mixed sentiment surrounding Brexit negotiations.
Therefore, it’s no surprise that defined benefit (DB) pension funds in Europe have revelled in the sight of improved funding levels. Trustees, sponsoring employers, and other fiduciaries, have also been able to take forward steps towards their end-game pension strategies by de-risking their portfolios.
However, valuations across both risk reducing and return-enhancing assets appear stretched, and macro and geopolitical risks are likely to continue. To make matters worse, global equity markets have been suffering a very torrid time due to the spread of the coronavirus disease, Covid-19, which emerged in China in December. The dearth of assets or investment strategies that can generate positive returns and income, to meet investors’ spending needs, represents the biggest challenge currently facing all major institutional investors.
We postulate the case for well-constructed, diversified multi strategies, anchored on a portfolio protection strategy, to deliver the risk-adjusted returns that investors demand
With that backdrop, and the risk of a significantly declining stock market, we feel that now is the time to adopt a different approach to constructing return-seeking portfolios, particularly those that feature traditional single asset classes. In this paper, we postulate the case for well-constructed, diversified multi strategies (or ‘Multi Strategy portfolios’), anchored on a portfolio protection strategy, to deliver the risk-adjusted returns that investors demand.
Key Takeaways
- During stress periods, when equities fall sharply, most hedge funds have failed to provide a ‘hedge’ against large losses due to moderate-to-high correlations with equities. For that reason, we believe an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios.
- For a Multi Strategy portfolio to generate consistent returns uncorrelated to equity markets, the underlying investments strategies must be sensible, persistent, additive, consistent and transparent.
- Investors in these portfolios may minimise netting cost and avoid the extra layer of fees associated with fund of funds.
DIVERSIFYING STRATEGIES
The case for Multi-Strategies as a diversifying alternative strategy
Well-constructed Multi Strategy portfolios may address past shortcomings of hedge fund programs. The past 20 years of hedge fund investing experience has been invaluable in evaluating and designing truly diversifying strategies that also meet the return objectives of institutional investors.
Our research and investing experience indicate that sound Multi Strategy portfolios manifest the best qualities of well-diversified hedge fund programs. They invest in statistically independent and economically sensible investment opportunities, should incorporate explicit portfolio protection against large equity drawdowns, and provide diversification to the rest of a portfolio’s assets by intentionally limiting exposure to equity beta. Finally, they minimise fees and netting cost that are so prevalent in direct hedge fund programs and funds of funds.
Sensible, persistent, additive and consistent1 and transparent
Most hedge fund strategies have historically provided limited diversification benefits because they were too highly correlated with equities and with each other. And, to make the matters worse, they often provided limited or no transparency to the underlying investment strategies, even during periods of persistent underperformance.
For a Multi Strategy portfolio to generate consistent returns unrelated to equity markets, the underlying investment strategies must be sensible, persistent, and additive. By sensible and persistent, we mean there must be a good economic intuition in relation to why the investment opportunity exists today, and will persist into the future.
To be additive, we believe investment opportunities must be independent, unrelated to one another and to equity markets.
From an investor’s perspective, transparency is also important. It is unacceptable for hedge fund managers to hide behind the veil of secrecy in good times and bad.
The example of a bank risk transfer strategy (see section below) exemplifies a risk premium that we consider to be sensible, persistent, additive, consistent and transparent. This structural risk premium arose because of new banking regulations following the 2008 GFC. As long as banks are required to offload risks from structured note sales, one should expect to collect a premium by providing liquidity and risk transfer services (sensible and consistent). We expect this risk premium to persist if banks are restricted – by banking regulations – in how much risk they can hold on their balance sheets.
Finally, the source of risk premium is idiosyncratic and generally independent of other risk premia (additive).
Chart 1:
Hedge fund correlation with equities

Correlation based on 3-Year Rolling Monthly Returns (31/1/1994 - 31/12/2019). Source: Bloomberg. Returns shown in USD
PORTFOLIO PROTECTION
The need for explicit portfolio protection
History has shown that during stress periods, when equities fall sharply, most hedge funds fail to provide a ‘hedge’ against large losses due to moderate-to-high correlation with equities. Seemingly unrelated investment strategies become highly correlated and the associated risk premia tend to widen across the board during stress periods (Chart 1).
In the past, to minimise the cost of portfolio protection, many investors sought to mitigate equity tail risk via implicit, instead of explicit, portfolio protection. They did so to mitigate the cost of portfolio protection. Generally, this approach hasn’t worked: the track record for implicit portfolio protection strategies have been mixed, many behaving like high-deductible insurance plans that participate in losses. We believe an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios and, to be successful, must seek to:
Generating uncorrelated positive returns in periods of sustained equity market sell-offs is one of the key objectives of diversifying strategies.
And, since “markets can remain irrational longer than you can remain solvent”, as quipped by John Maynard Keynes, it is important that Multi Strategy portfolios remain solvent and invested in other investment strategies (that may be negatively impacted by an equity sell-off). This could then capture long term positive expected returns.
Netting cost and hedge fund fees
In multi-manager hedge fund programs and funds of funds, the results of out-performing managers are usually offset by the results of under-performing managers; however, there are no offsets between managers when it comes to incentive fees. Institutional investors pay incentive fees to the outperforming managers but do not receive an incentive fee rebate from the underperforming managers. As a result, investors may end up paying incentive fees even when the overall hedge fund program or fund of funds fail to generate excess returns above benchmark.
Earlier, we stated, “...an explicit portfolio protection strategy is integral in diversifying Multi Strategy portfolios” However, netting cost can be particularly acute for portfolio protection strategies (i.e., negative correlation strategies) because they are designed to generate positive returns in periods of sustained equity market sell-off. For that reason, in direct multi-manager programs and fund of funds, the inclusion of portfolio protection strategies can exacerbate netting cost.
By comparison, Multi Strategy portfolios avoid netting cost associated with low or negative correlation strategies because investors pay incentive fees at the aggregate Multi Strategy level, instead of at the underlying strategy level. Notwithstanding, netting cost still exists – even for Multi Strategy portfolios – at the overall portfolio level, if two or more Multi Strategy portfolios are used. For that reason, investors minimise, but do not completely eliminate, netting cost at the portfolio level.
Beyond minimising netting cost, Multi Strategy portfolios can be a superior choice for smaller DB pension funds that currently gain exposure to hedge fund strategies via a fund of funds. Ibbotson, Chen and Zhu – in “The ABCs of Hedge Funds: Alphas, Betas, & Costs” (30 March 2010) – estimate hedge fund fees at about 3.8% per year. In our estimation, the all-in fee for fund of funds investors is closer to 5.0% due to the triple layer of fees: hedge fund manager fees (3.8%), fund of fund fees (~1.0%) and consultant fees. With Multi Strategy portfolios, investors avoid a layer of fees associated with fund of funds. In the current environment, where cash is yielding zero in many parts of the world and excess returns are difficult to harvest, a fee reduction of 1.0% represents a material saving for any investor.
CONCLUSION
According to Barclays' 2019 Global Hedge Fund Industry Outlook, “...investors indicated they are looking for just over 7.0% [target of 7.4%] from their hedge fund allocations...”. A return target of 7.4% – in line with the required rate of return of institutional investors – should be achievable for well constructed Multi Strategy portfolios that target moderate level of risk.
However, it is not enough for Multi Strategy portfolios to deliver on the return target only; they should do so with returns uncorrelated to equities and with portfolio protection during periods of market stress. In an environment where, increasingly, risk and risk-free assets are rising or falling in concert based on government and central bank monetary policies, well-diversified Multi Strategy portfolios can be positioned to provide a hedge against tail-risks when stocks and bonds together witness sharp falls.
Multi Strategy portfolios based on sensible, persistent, additive, consistent and transparent investment ideas, coupled with an explicit portfolio protection strategy, should deliver to the original objectives of institutional hedge fund programs. And, as noted earlier, they may provide a more fee-efficient exposure than direct multi-manager programs or fund of funds.
Finally, with a slew of indicators showing macro and geopolitical risks are likely to continue in the future, and the need for truly diversifying alternatives, we firmly believe Multi Strategy portfolios deserve a prominent role within institutional portfolios.
1 Also referred by the acronym ‘SPAC,’ Barclays Global Investors popularised this investment concept back in the 1990s and early 2000s.
2 Anita Raghavan, “A Way to Play European Stock Dividends,” Barron’s 31 March 2019.