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Original Risk: A Society for Change Agents

ILS & reinsurance are Hedge Funds 2.0, says Future Fund CIO


The world of hedge funds and alternative investment strategies is moving fast and the Chief Investment Officer of massive A$166 billion Australian sovereign wealth fund, the Future Fund, is happiest allocating to what he terms Hedge Funds 2.0, a categorisation that ILS and reinsurance fits into.

Speaking at the i3 Investment Strategy Forum in Victoria, Australia last Friday, Future Fund CIO Dr Raphael Arndt explained his thinking behind allocating to hedge funds, saying that the new breed of alternative investment managers are moving far beyond the more traditional vision of what is a hedge fund.

With a mandate to deliver returns of, “at least inflation plus 4 per cent per annum over the long-term, without taking excessive risk,” hedge funds play an important role in the investment strategy of the Future Fund.

The sovereign wealth fund is already invested in the ILS sector, having allocated capital into reinsurance linked assets through allocations made to Elementum Advisors in 2015 and Hiscox Re ILS in early 2016.

The Future Fund has a desire to grow its allocations to reinsurance over time, having already found a liking for the asset class, but it’s particularly encouraging to hear from the CIO that, as an asset class, the Future Fund categorises ILS firmly in the bracket of hedge fund strategies built for the future.

Arndt explained his thinking on the hedge fund sector, “I recognise that hedge funds have historically had a public relations problem – being associated with high fees, a lack of transparency and perceptions of poor ethics and customer focus. In many cases they were also just an expensive access point to buy equity market beta. They failed to deliver on their protection promise – generally delivering the same low or negative returns as equities during the GFC.

“I would call this dated stereotype ‘hedge funds 1.0’. A lot has changed. Today I will talk to you about the move from ‘hedge funds 1.0’ to ‘hedge funds 2.0’.”

He went on to say that the “new generation of hedge funds” play an important role in delivering uncorrelated returns to the Future Fund, while also helping to reduce risk across its portfolio.

Given the current investment environment, the global economy, the high price of assets generally and other macro factors, Arndt said that the Future Fund looks for flexibility, assets that are uncorrelated to equity returns, and investment strategies that reflect, “genuine innovation and adding value to businesses – not just financial engineering or strategies that involve leverage.”

Hedge funds help by offering portfolio diversification and uncorrelated returns, Arndt said, which for the Future Fund reduces risk by offering, “returns during market environments involving prolonged periods of losses in equity markets.”

In general the Future Fund looks for a hedge fund strategy that offers “diversification, downside protection, and alpha generation,” something the sovereign wealth manager finds in ILS and reinsurance.

The reinsurance and ILS assets sit within the alternative risk premia bucket for the Future Fund, an important diversifier and return driver for the fund, providing “return streams largely unrelated to financial market assets.”

“These strategies are designed to provide diversifying returns, so that in other parts of the portfolio we can invest into riskier assets like equities and illiquid assets such as infrastructure, private equity and property, while maintaining an appropriate total portfolio construction,” Arndt said.

He provides some valuable advice for those ILS managers looking to work with an investor like the Future Fund.

Saying, “We want to see a manager demonstrating real skill over time, not just generating returns from exposures to market beta or factors such as value or momentum.

“When assessing performance and fees paid, we want to be paying for alpha, not beta. We look at how the alpha generated is split between investors and the fund manager. We expect to keep the majority of the skill based return, and not pay it away in fees.

“Finally, we look for the right level of transparency. A list of all of a fund’s assets once a month or quarter may be interesting but is often of limited utility.

“Real transparency comes from having exposure data that matters, and from an open and genuine dialogue with a manager.

“We seek to partner with our managers, and draw from their insights to help inform our portfolio thinking, and hopefully we help shape their thinking too.”

Arndt also said that the Future Fund is happy to seed new managers, where it can achieve favourable terms, which should encourage the start-ups in ILS, as long as they have something different or innovative to offer.

But most importantly, the Future Fund looks for hedge funds 2.0, not their predecessors from the 1.0 hedge fund era.

“The ‘have a hunch, bet a bunch’ hedge fund manager is a relic of a bygone era, largely cleaned out by the GFC which exposed strategies which use high leverage and poor risk controls.  These have been replaced by institutional quality investment processes.

“High-speed data analysis and multi-faceted risk systems have more value in modern markets than stock tips on the golf course.

“In our experience, the hedge funds depicted in the TV show Billions are no longer relevant for institutional investors, having been replaced by managers making huge investments in data and technology.”

Of course ILS strategies utilise significant investments in data and technology to provide them the insight and research to make better investment decisions and this is only going to accelerate as the technology available to analyse risk improves all the time.

Arndt said the Future Fund will measure its hedge fund performance in terms of diversification, downside protection and alpha generation.

The hedge fund program at the Future Fund has been delivering as well, Arndt explained, “Over the last five years the hedge fund program has been significantly increased in size, both in absolute terms and as a proportion of the total Fund, as we have sought to emphasise the downside protection the program delivers.

“At the same time, as I touched on earlier, I am pleased to say the program’s correlation to equity markets has fallen to nearly zero, as we obtain market beta exposure more efficiently elsewhere.”

Explaining their importance he closed, “While a meaningful hedge fund program is rare among Australian institutional investors, I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC type event in equity markets.

“The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.

“I also call on consultants, who might currently rank funds according to fees paid, to properly assess the risks associated with equity market exposure. Doing so may lead to increased appreciation of the true value of diversifying strategies.

“Importantly, an effective hedge funds program allows an investor to buy into a down market rather than being a forced seller if we have a repeat of a GFC like selloff.

“While I hope we don’t experience a significant downturn in equity markets, I feel much more comfortable having 15% of the Future Fund in hedge funds to provide some protection against the possibility that markets turn.

“It’s time to re-examine what hedge funds offer. The industry has evolved and improved, and features a new breed of managers that are different from their predecessors. They have changed their approach. I believe that it is time we all did the same.”

It’s encouraging to hear from one of the world’s largest pension investors the important role that alternatives and hedge funds play. It’s especially encouraging to hear reinsurance as an asset class placed firmly in the bracket of hedge funds 2.0.

As more institutional investors gain similar appreciations for ILS and reinsurance as an asset class, the only question will be whether the sector can put the money to work.

We thought inflows had been strong in ILS so far, if more investors of the stature of the Future Fund begin to think this way they could be dwarfed by what comes next.

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