One of the concepts I have been talking about recently is 'Un-learning'. Un-learning is about:

• questioning assumptions around portfolio theory that have become conventional wisdom;
• choosing when to reject some of the time tested data and past research on hedge fund investing;

Un-learning then facilitates the application of contemporary, fresh thinking to asset allocation and particularly hedge fund investing.

It is a given that we should learn from our mistakes; but I have recently advocated a somewhat contradictory approach: I call it un-learning. This is about questioning the assumptions that have become conventional wisdom. It's also about ignoring some of the time tested data and past research ‐ and also about forgetting the good old days. However, choosing what to un-learn needs to be selective and based on context.

The arguments for holding hedge funds as part of an allocation to diversified portfolio remain as strong as ever. Hedge funds provide an important balancing element to a traditional stock/bond portfolio. However, in recent years institutional investors have felt somewhat short-changed, as recent hedge fund returns have not matched those of previous eras.

Hedge funds are not an asset class and fund selection remains a critical part of the process. Structural forces of the past may be different to those in the future, this challenges the consensus view and highlights the pitfalls of relying on historical data to make forward-looking decisions.

Background: Why have investors traditionally invested in hedge funds?

Effective hedge fund allocation can substantially limit the downside risk of a portfolio. The below chart clearly shows the benefit not only of reducing volatility, but enhancing performance over the long-run by allocating to hedge funds.

Hedge funds' declining performance

While the impact of performance still looks good from a long term perspective, investors have become disenchanted with performance in recent years and they have every reason to question returns. Collectively, hedge fund performance is in decline.
UN-LEARNING

Modern Portfolio Theory

• With the onset on rising yields (at least in the US), traditional portfolio theory will be seriously challenged in the coming years. It is our perception that most institutional portfolios are constrained to have their defensive allocation shackled to long-only fixed income funds, despite the consensus view of either continued ultra-low rates or even rising interest rates. The 30-year bull market in fixed income needs to be "un-learnt" and portfolio theory needs to upgrade to match modern day strategies and instruments.

Hedge Fund Investing

• The history of hedge fund performance is just that, history. The trend is clear, the good old days are gone and identifying the best managers becomes more difficult as the proportion of outstanding managers diminishes. As the number of funds has ballooned, so has the number of very average funds, and the overall industry performance has converged to either zero or index-like (i.e. equity) returns.
• When building a hedge fund portfolio manager selection is of paramount importance and requires skill, expertise, and resources. It is not enough to rely on past, or current, performance or to choose strategies because they are performing now. The key is to identify managers that have a proven ability to generate returns through the market cycle and the ability to adapt to changing environments.
• Often hedge funds will change over time themselves, thus making their track record a poor representative of any future performance; this is where intense and rigorous investment monitoring is required.

Case Study - Trend-following strategies: I recently returned from Asia where Aurum are discussing a bespoke portfolio for a client who, 5 years ago allocated to a systematic trend-following hedge fund, commonly known as a CTA (Commodity Trading Advisor). They chose the CTA because it made money in 2008. They didn't get the benefit of the 2008 performance and their investment is down double digits since investing.

Currently Aurum has no CTAs exposure. Post-2008 we asked ourselves a simple question: "are CTAs able to model the worlds' central banks' policy responses to the crisis?" We have observed over time that there are few managers and investment styles that can make money when markets move in a trendless and volatile range. Post-2008, this is where we believed we were heading. We 'un-learned' the persistence of CTA performance, if we had relied on history, we would have lost money.

Reckless conservatism and regulatory hurdles

• It seems ironic that, at a time when regulators have gone into overdrive, it could be said that hedge funds have never been safer. This is where another bout of un- learning may provide perspective.
• The demise of Lehman and the Madoff fraud are interesting history lessons. They became a force for change. Hedge fund transparency, disclosure, liquidity, fees, governance, reporting and communication have all taken giant leaps forward since.
• Self-imposed guidelines and regulations are also pushing investors towards seeking alpha from liquid alternatives, e.g. via UCITS. However, the restrictions and liquidity requirements are very onerous to managers – "are investors in these products really getting what they think they are paying for or is this just expensive beta?"
• A recklessly conservative combination of regulations and investment policy may be handicapping pension funds by limiting choice and flexibility.

Return expectations

• Despite interest being pushed to ultra low levels, some investors still regard double digit returns with low volatility and low correlation, as entitlements.
• It is time to un-learn what hedge funds achieved in the early years and apply realistic expectations about future returns, based on the significant changes that have taken place in the industry and the environment.

Fund of hedge funds (FoHFs)

• The bear market of 2002 marked the start of a golden age for FoHFs; it was when institutions began to notice hedge funds. Traditional portfolios were taking a beating and hedge funds were performing substantially better. FoHFs were the vehicle of choice up until 2008, because they provided access to a new asset class and offered a well researched, diversified portfolio of managers. Since 2008 there has been an increasing trend toward direct investment. However, in recent months we have seen signs this is reversing. With investors coming back to FoHFs, having struggled to build successful portfolios themselves. A lot of new interest in FoHFs is around bespoke and segregated solutions. We see this trend continuing.
• Pension funds in Europe are facing a new hurdle to access: the Alternative Investment Fund Managers Directive (AIFMD). Non-EU managers have already stopped promoting funds in Europe, put off by confusing and inconsistent implementation of AIFMD and associated costs of complying. Some larger non-EU hedge fund managers will likely set up EU vehicles in time. Although, not all will and investors simply can't invest in funds that they don’t know exist. FoHFs may be the natural choice for European investors. An AIFMD compliant FoHFs can provide exposure to the widest opportunity set available.
• It is time to re-evaluate FoHFs, particularly those who have applied lessons learned through the crisis and modified their businesses.

Conclusion

We are in a world of low interest rates and low growth. A world where traditional fixed income allocations may not provide the protection and diversification that has been enjoyed in the past. Hedge funds add a differentiated return stream to traditional portfolios. However, identifying those managers that will meet performance and risk expectations is an intensive task. Regulation that has been designed to protect investors may in fact be limiting choice, competition and opportunity.

Investors should question the myths and data around hedge funds and ensure they have current and relevant information to base their decisions on. Seeking the help of a FoHFs may once again be the most sensible route. A healthy dose of un-learning with the possibility of new and unexpected insights, may be just what current investment philosophy needs.