A year in review

Historically, most investors obtained their hedge fund exposure by buying off-the-shelf fund of fund products. The largest hedge fund allocators have evolved their approach to construct hedge fund allocation using customized mandates that better represent their specific objectives and constraints. These may be outsourced portfolios or built by in-house research teams. Both methods require significant capital allocation and industry expertise, creating barriers to entry for allocators to introduce hedge funds to their portfolios.

abrdn Eclipse is a customizable hedge fund platform that allows investors to make discretionary allocations to hedge fund strategies through a passive benchmark tracking approach. HFR is the leading hedge fund benchmark provider, and the abrdn Eclipse platform hosts funds (segregated portfolios) that track the investable HFR indices. 

abrdn Eclipse offers investors a passive route to access hedge fund alpha, making hedge fund investing efficient and cost-effective.

Each segregated portfolio tracks a corresponding HFR index by investing in all the underlying constituents of the target index at the index weights. Therefore, it can deliver benchmark returns with minimal expected tracking error.

Figure 1 shows the quarterly returns of the HFRI 500 Index and abrdn Eclipse HFRI 500 tracker fund (SP), as well as the 1-year return (July 22 to June 23).

The Segregated Portfolios (SP) on platform have successfully delivered its investment objective. As shown in Figure 1, the top-level abrdn Eclipse HFRI 500 SP tracked the hedge fund benchmark (HFRI 500 Index) consistently and outperformed the HFRI 500 Index by nine basis points last year due to economies of scale and fee savings.

Moreover, the hedge fund industry delivered positive performance in three out of four quarters, with the largest return coming in Q2 2023¹. In the next section, we look at performance attribution of the hedge fund universe.

The HFRI 500 Index is a leading investable hedge fund benchmark. It comprises four strategies: Equity Hedge, Event Driven, Macro, and Relative Value, each broken down into two sub-strategies, making a total of eight sub-strategies. The abrdn Eclipse platform currently has nine live SPs that track the top-level HFRI 500 Index and each of the eight sub-strategy indices. Investors can gain exposure to the four strategies by investing in the two relevant sub-strategy SPs. For example, Long/Short Equity SP combined with Equity Market Neutral SP at appropriate weights will track the Equity Hedge Strategy Index.

As represented by the HFRI 500 Index, the hedge fund industry has been resilient over the last year. Equity Hedge, Event-Driven, and Relative Value all produced positive returns, while Macro was the only strategy that detracted, as shown in Figure 2.

Looking at the sub-strategy level, six out of eight sub-strategies were up over the last 12 months, with Event-Driven, Multi-Strategy, Long/Short Equity, and Fixed Income Relative Value leading gains, while Equity Market Neutral, Merger Arbitrage, and Discretionary Macro made a modest positive return.

Systematic Macro and Volatility Relative Value, which typically perform best in trending and bear markets, respectively, were the only sub-strategies with negative performance, as seen in Figure 3.

Both sub-strategies detracted in 2023 as the equity market made a solid but choppy recovery, reaching near all-time highs at the end of June 23. Market volatility, as measured by the CBOE VIX index, fell to lows not seen since the end of 2019 before the COVID outbreak.

Event-Driven Multi-Strategy had the most robust performance last year out of eight sub-strategies, with 75% of the underlying funds making a profit. Distressed/Restructuring managers were the standout performers within the sub-strategy.

Long/Short Equity funds also produced robust returns. Both Fundamental Growth and Fundamental Value managers performed well, benefitting from the rebound in global equity markets. In addition, Fundamental Growth managers had the backwind of the strong uptick in technology stocks fuelled by optimism about the advancement in artificial intelligence (AI).

Finally, within Fixed Income Relative Value, managers that invested in sovereign bonds experienced the highest performance.

Investors allocate to hedge funds for the benefits of diversifying returns from traditional asset classes and return enhancements. However, the impact and magnitude of these benefits will vary significantly depending on the hedge fund you choose. The wide dispersion of returns between hedge funds makes active selection difficult. On the other hand, hedge fund investing via benchmark tracking helps to reduce selection risk, resulting in a portfolio with lower volatility, largely thanks to the diversification benefits of investing in many uncorrelated hedge funds (see more detail in the next chapter).

Figure 4.1 shows the return dispersion of the underlying funds by sub-strategy in box and whisker charts. Looking across the sub-strategies, the range of return (distance between whiskers) is extensive. In comparison, the interquartile range (the length of the box represents 50% of the funds) is on a much tighter scale.

Take Long/Short Equity as an example; the range of return is around 65%, with the best-performing fund returning +40% and the worst-performing fund returning -25%.

However, the interquartile range shows that 50% of the Long/Short Equity funds’ performance falls between 0% and 10%, with a median of 5%. The relatively narrow interquartile range shows that there is limited value-add in active fund selection.

Looking at the tail ends of the return spectrum; we note that investors take on a significant amount of fund selection and headline risks when picking individual funds. Figure 4.1 exhibits that some “unlucky” investors picked a long-biased European equity-focused fund that lost 25% in a market where most Long/Short Equity funds made money.

For investors that have the necessary resources to pick funds, abrdn Eclipse provides an effective tool for portfolio completion. Furthermore, investors can use the platform as a transitory vehicle and earn benchmark returns on undeployed cash. Core/Satellite is a popular investment approach that uses passive instruments and could also be a valuable tool in hedge fund investing. Investors can use a passive hedge fund tracker to gain benchmark returns and build a more concentrated position in high-conviction funds.

Dispersion of return in Discretionary Macro illustrates the significant fund selection risks that allocators confront in hedge fund investing. Figure 4.2 shows that while most of the Discretionary Macro funds made money in 2023, one fund lost over -45% in one month alone (March 23).

This particular manager was caught up in the financial sector turmoil caused by the insolvency of Silicon Valley Bank, and the fund went into liquidation the following month. In active hedge fund selection, an event such as this would likely significantly impact a portfolio, removing any potential diversification benefits, and creates unwanted headline risk. In contrast, headline risks/ idiosyncratic risks are minimised in a passive benchmark tracking product.

Merger Arbitrage has the lowest return dispersion of the eight sub-strategies. While Merger Arbitrage does not represent a big portion of the industry assets, it is well-known and widely invested. However, Figure 4.2 shows that return dispersion is low, with a small range between 0% and 5%, indicating little value in selecting funds. An allocator can capture most of the Merger Arbitrage strategy premia through passive allocation.

Risk reduction in hedge fund allocation is one of the most significant benefits of passive investing, whether in traditional markets or in hedge funds. Investing in a large number of securities/funds introduces more uncorrelated assets to the portfolio, resulting in lower volatility at a portfolio level.

Figure 5 shows the average volatility of HFRI 500 Index constituents, the volatility of a typical FoF observed through 1000 random samplings of 10-funds portfolio, and the realised HFRI 500 Index volatility. 

We note that we can reduce the volatility of a typical FoF by 30% from 6.3% to 4.3%.

Hedge funds come in all shapes and sizes. Their investment strategies are often opaque and esoteric to outsiders. Some hedge funds place risky bets and have a very volatile return stream, while others focus on risk management and have little downside tolerance. Figure 6 shows the monthly return of all constituents of the HFRI 500 Index in a heatmap, giving a bird’s-eye view of the hedge fund universe.

Each row in Figure 6 represents a hedge fund and its monthly returns over the last twelve months in a colour scale, with the intensity of the colour blue representing the magnitude of a positive return and the strength of the red representing the size of a negative return (The scale is capped between +30% and -30%). 

Looking at the top section of the Figure, we see that around a quarter of the hedge fund universe have vast return volatilities, with monthly returns oscillating between +15% and -15%, and it is not uncommon to see a large print of over 20% in both positive and negative direction; the regular blue and red colour switch on the top section of the Figure 6 illustrates this. However, looking at the bottom half of the Figure, we saw that the majority of the hedge funds have a low-risk appetite, where we rarely see a monthly return that goes beyond ±10%, with most of them having monthly returns of less than ±5%.

Looking at the Figure vertically, we saw that in June 23, most of the hedge fund universe made profits, as indicated by the overwhelming blue prints, while in September 22 hedge funds had a difficult time making money, as shown by mostly the red prints. However, during other periods, we see little pattern in hedge fund returns, which further illustrates the uncorrelated nature of the hedge fund strategies.