Stockholm (HedgeNordic) – The hedge fund universe is heterogeneous, with the objectives, complexity, costs, and risk-return profile of each hedge fund varying widely. However, institutional investors mostly turn to hedge funds in their pursuit of an investment that is uncorrelated with the rest of their investments. For Finnish pension insurance company Elo, the primary advantage of investing in hedge funds is the diversification benefit from adding an asset class that offers uncorrelated returns relative to traditional equity and fixed-income investments.

“Hedge funds offer investors exposure to a return stream that has low correlation to traditional assets such as stocks and bonds,” explains Mika Jaatinen, Portfolio Manager of Hedge Fund Investments at Elo. “For us, this low correlation is key,” he emphasizes. “Funds themselves gain this low correlation either by investing in relative value strategies, directional macro strategies, highly complex quant strategies or opportunistic event-driven strategies.” Coming in many shapes and colors, hedge funds exhibit a relatively weak correlation with other asset classes, as well as play important risk-reduction and return-generating roles in a portfolio.

“Hedge funds offer investors exposure to a return stream that has low correlation to traditional assets. Hedge funds certainly have a proven place in the financial ecosystem.”

“Hedge funds certainly have a proven place in the financial ecosystem,” argues Jaatinen, who is responsible for hedge fund allocation at Elo since 2007 as part of Pension Fennia before Elo was formed in 2014. “They can offer investors ways to diversify their balance sheet exposure in a fairly liquid way,” elaborates the portfolio manager. “Hedge funds can also offer investors access to investment strategies that are hard or even impossible to implement internally,” he continues. Yet, the biggest benefit of investing in the industry “comes from the uncorrelated return profile of hedge funds.”

Allocation Follows Macro Cycles

“Hedge funds can offer a different type of return stream. Something that is not totally relying on long-only exposures to traditional asset classes,” says Jaatinen. Relative value strategies, for instance, are designed to pick both winning and losing stocks, with the dispersion between winners and losers serving as the main source of their returns, according to Jaatinen. “There is clearly more volatility and dispersion in the markets right now,” highlights Jaatinen. “More volatility, the more there will be dispersion and that equals more alpha opportunities for hedge funds as a whole.”

“There is clearly more volatility and dispersion in the markets right now. More volatility, the more there will be dispersion and that equals more alpha opportunities for hedge funds as a whole.”

The opportunity sets harvested by hedge funds, which are shaped by shifts in the macroeconomic environment, determine the extent of Elo’s allocation to the hedge fund space. Elo’s hedge fund allocation has gradually declined from 9.5 percent of the overall portfolio at the end of 2017 to 7.1 percent at the end of 2020 before rebounding to 7.4 percent at the end of last year.

“Elo’s allocation to hedge funds has fluctuated over time based on macroeconomic cycles and general market opportunity set,” explains portfolio manager Mika Jaatinen. “Hedge funds perform best when there is enough volatility and dispersion available in underlying asset classes,” he emphasizes. “Volatility and interest rates were at historically low levels before the pandemic. The same was true for credit spreads.” This created a very challenging environment for hedge fund players.

“Elo’s allocation to hedge funds has fluctuated over time based on macroeconomic cycles and general market opportunity set.”

“The pandemic brought along more dispersion and threat of possible inflation. That has improved the opportunity set for hedge fund strategies considerably,” considers Jaatinen. “Possible inflation brings along more volatility in all major asset classes,” which may reinforce the drive into hedge funds by institutions. “There will be more defaults, rise in commodities prices and reprising of equities and credit,” argues Jaatinen. “This means good opportunities for macro-, CTA-strategies during the greatest turmoil and opportunities for relative value and opportunistic strategies in credit and equity after things have settled a bit.”

Intro to Elo’s Hedge Fund Portfolio

Investors typically allocate capital to hedge funds to access return, risk and diversification characteristics that are not easily accessible in other investments. The hedge fund universe is heterogeneous and there is a wide variety of strategies and styles that can help investors access those characteristics. Finnish pension insurance company Elo has built a diversified hedge fund portfolio, worth €2.2 billion at the end of 2021, to capture those idiosyncratic characteristics. “Elo’s hedge fund portfolio is consisting of a wide array of various hedge fund strategies,” says Jaatinen. “All the main underlying asset classes are present – equities, bonds, credit and commodities futures – and our hedge funds are using these assets in various ways.”

Relative value, directional and quantitative hedge fund strategies are tapping mostly equity, bond and futures markets as their source of returns, explains Jaatinen. Meanwhile, opportunistic strategies such as distressed credit and activist strategies are mainly using credit and equities as their source of returns. “Hedge fund strategies are not just offering us uncorrelated return streams, but they are also giving us exposure to investment styles that are not executed internally,” argues Jaatinen. “The combination of all of this, Elo’s hedge fund portfolio, is a fairly market neutral entity, with low correlation and steady return stream.”

“Hedge fund strategies are not just offering us uncorrelated return streams, but they are also giving us exposure to investment styles that are not executed internally.”

To build a successful hedge fund portfolio, the team at Elo follows a thorough review and due diligence process on potential hedge fund investments. “We get information from various sources. We meet managers and industry experts. We use third-party analyses and databases. We also use our own internal quant analysis tool for assessment of risk, peer comparison and overall suitability of individual funds for our current balance sheet,” Jaatinen describes Elo’s review process. “In addition to that, we try to follow and monitor prospective managers for years, before we engage with them,” he emphasizes. “Proper due diligence is important not just because it decreases risk, but because it increases opportunities for our long term outperformance.”

“A hedge fund holding is not just investment for us, it is also a long term relationship between Elo and fund managers.”

More importantly, “a hedge fund holding is not just investment for us, it is also a long term relationship between Elo and fund managers,” highlights Jaatinen. “We can exchange information between ourselves. Managers are feeding us information about new risks and opportunities in the financial markets and various regions,” he elaborates. “This information turns into new investment decisions or makes us aware of new potential risk somewhere. It’s a mutually value-adding relationship.”

Main Challenge: ESG

Investors are mostly allocating to hedge funds to achieve alpha and risk mitigation, with the latter stemming from diversification benefits, tail risk reduction, or diminished correlation. Most hedge fund investors and fund managers themselves have come to understand that neither of these objectives can be maximized without a commitment to sustainability. “Allocation is always a balancing act between expected risk and return in various asset classes and opportunities,” says Jaatinen. “Hedge funds can offer various kinds of solutions for you balance sheet diversification, but there are also other targets and policies that need to be met, like ESG.”

“The importance of a hedge fund manager’s approach to ESG depends on the strategy the manager is practicing.”

“The importance of a hedge fund manager’s approach to ESG depends on the strategy the manager is practicing,” explains Jaatinen. He goes on to add that an ESG focus is more meaningful for an equity long/short manager than for a fixed income relative value manager “as ESG issues are more pronounced in equities than in interest rates.” According to Jaatinen, “if the manager is ESG focused or has an ESG integration policy, we would like that policy to reflect both their core competencies and preferably also generate ESG alpha for our portfolio.”

“Currently there are not enough hedge fund managers that can offer ESG-focused products for institutional investors like Elo,” acknowledges Jaatinen. “Funds currently offered are either too small or they do not meet our investment criteria operationally,” he continues. “We are actively engaging with ESG within our hedge fund portfolio, but it’s going to take some time due to the availability of these funds. Luckily many of our current hedge fund holdings are incorporating an ESG approach into their existing strategies.”

This article features in HedgeNordic’s “Nordic Hedge Fund Industry Report.”