Finding alternative sources of returns that are uncorrelated to equity and bond markets is a key objective for institutional investors seeking to construct robust portfolios of investments. The growth of investments in hedge funds is a reflection of this. Their attractiveness lies in their ability to harness returns from alternative sources of risk premia that traditional managers have not been able to offer and this has justified a higher fee structure. But are institutional investors really receiving value for money? Idiosyncratic sources of risks and returns such as bets on mergers and acquisitions or arbitraging a specific convertible against a company’s equity and bonds require specific expertise that can justify the hedge fund fees. But other sources of hedge fund returns are systematic and accessible via approaches that are best regarded as tapping alternative sources of beta. Investors should not be asked to pay extra for gaining systematic access to sources of risk premia that are not true “alpha”.
Investment in the traditional assets classes of equities, bonds and property is a way of gaining systematic access to different types of risk premia, each of which produces an associated return. Equities have a well-known equity risk premium, which also includes outperformance arising from the small cap and value risk premia that have been well documented in the academic literature; bonds have an interest rate risk premium arising from the term of the bond in a normally upward sloping yield curve, together with credit/default risk premia for lower rated sovereign, corporate and securitised bonds; real estate, whether direct or through REITs, has risks associated with factors such as natural hazards, economic dislocationsetc; and in all asset classes, there is an illiquidity risk premium relative to liquid government bond markets.
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