Stockholm (HedgeNordic) – Kari Vatanen wasn’t a big fan of hedge funds when he joined Veritas as chief investment officer in March 2020 after more than a decade of underperformance. 2022 was a chance to ease his doubts about the role of hedge funds in institutional portfolios. Hedge funds have indeed proved useful for many institutional investors, including Veritas, in the challenging market environment of 2022. The hedge fund portfolio of Veritas, partly owing to Vatanen’s re-organization, returned an impressive 12.3 percent in 2022.
“Hedge funds have performed well in the environment of rising rates and declining equity markets. We have reported double-digit returns for the whole alternatives portfolio and over 12 percent for hedge funds only,” says Vatanen. This alternatives bucket only refers to hedge funds and alternative strategies and does not encompass private equity or real estate, which represent separate asset classes. “The diversification effect of hedge funds and other alternatives has been significant, and they have mitigated the negative return impact of equities and fixed-income,” he emphasizes. This diversification effect wasn’t as visible during the Covid-induced market turmoil in the first quarter of 2020.
“The diversification effect of hedge funds and other alternatives has been significant, and they have mitigated the negative return impact of equities and fixed-income.”
“Hedge funds were part of asset allocation at Veritas before my time here and were meant to play a diversifying role,” according to Vatanen. The hedge fund portfolio offered many – mostly negative – surprises when Vatanen joined Veritas at the beginning of March 2020, when the Covid crisis started. “We noticed in my first month here that our hedge fund investments did not hedge at all,” he recalls. “As a hedge fund investor, you have to understand the behavior of your hedge fund investments in different market environments,” according to Vatanen.
Different Roles for Different Hedge Funds
Soon after taking the helm of investment functions at Veritas as CIO, Vatanen and his team started moving the entire portfolio into three different functional buckets: carry-seeking, diversifying and hedging. As part of the process, Veritas simultaneously started re-organizing the alternatives portfolio based on each strategy’s function. The alternatives portfolio, which consists of hedge funds and other hedge fund-like specialist strategies such as insurance-linked strategies, may fit in any of these three buckets. “We have done quite a lot of work to understand the profile of each hedge fund and alternative investment and how it behaves when the market regime changes,” explains Vatanen.
“We have different roles for hedge funds and other alternatives depending on their risk characteristics and expected returns,” elaborates Vatanen. “Hedge funds can be either alternative sources of carry or they can provide diversification or even hedging effect for risk-on assets.” In the pool of alternative investments, which accounted for 13.2 percent of the €4.2 billion investment portfolio at Veritas at year-end, all three functional buckets ended 2022 in positive territory, with tail risk hedging driving the performance. The entire alternatives portfolio returned 10.2 percent in 2022.
“We have different roles for hedge funds and other alternatives depending on their risk characteristics and expected returns.”
The tail risk hedging part of the alternatives portfolio was the best performer in 2022, generating a return in the high-teen percentage range. The diversifying and carry parts delivered positive returns as well. “All parts of the portfolio performed positively, but the best performer was tail risk hedging, which offered protection to decreasing equity markets, rising rates, and rising credit spreads,” summarizes Vatanen. By design, the return profile of the hedging component is designed to generate returns when equity markets go down. “We have both alternative risk premium strategies from investment banks and a couple of asset managers that focus on defensive and risk hedging strategies. These are not direct hedges that we are used in other parts of the portfolio.”
The alternative carry-seeking bucket mostly includes private and structured credit dislocation and special situations, or credit event-driven type of investments. “There is illiquidity embedded in this type of strategies, which means they are not as interest rate sensitive compared to traditional fixed income,” explains Vatanen. Volatility-selling strategies are also part of the alternative carry-seeking bucket. The diversifying alternatives bucket, meanwhile, includes macro and relative value hedge fund strategies, insurance-linked strategies and diversifying risk premia strategies. “This package includes strategies that are not highly tail-correlated compared to other asset classes,” according to Vatanen.
The new philosophy of portfolio construction based on each investment’s function enables Kari Vatanen and his team to adjust allocations as market conditions change. “If our market view is that we need more hedging or more diversification, we tilt the portfolio towards that,” says Vatanen. With hedging strategies exhibiting a negative return profile over time, Vatanen relies on a “semi-active approach to the hedge fund allocation to adjust the risk profile depending on the market environment.”
The current market environment favors active management, including a wide range of hedge fund strategies, according to Vatanen. “We expect that the current market environment is better for active management and for many diversifying macro hedge funds compared to the environment of negative rates and massive QE,” he predicts. The market dominance by central banks has started to decrease, which has caused a rise in macro volatility. “The trends in the macro variables such as rates and FX strengthen, which has been positive for any trend-followers like CTA funds.”
According to Vatanen, market fundamentals have begun to play a bigger role in equity markets as well. “The importance of value and expected cash flow measures is increasing when borrowing costs are positive again,” he explains. “Diversifying hedge funds that are not relying on credit or equity market beta, might have a better working environment now.” Despite fundamentals playing a bigger role in equity markets, Vatanen does not prefer long/short equity managers. “We could have some if they are exceptionally interesting or attractive, but this is not our preference as we have a separate long-only equity portfolio where we can have active funds.”
“Diversifying hedge funds that are not relying on credit or equity market beta, might have a better working environment now.”
After a strong performance in 2022, Vatanen continues to prefer diversifying macro strategies, relative-value strategies and even tail risk hedging strategies amid a lot of uncertainties in the current environment. “We are a little bit cautious on economic expectations for now, and that’s why diversifying and tail risk hedging strategies are still our preference,” says Vatanen. “But little by little, opportunities might arise in alternative carry on the opportunistic credit side, for instance,” he emphasizes.
The performance of hedge funds had not been attractive in the decade after the financial crisis compared to the risky asset classes such as equities, credit, and private assets, according to Vatanen. “But are we now at a turning point when macro strategies start to perform and risky assets start to suffer?” he asks. One reason for the market environment arriving at this turning point is the end of the quantitative easing by central banks. “The big picture on our side is that after tough times for systematic macro strategies, there will be a renaissance for macro trading,” says Vatanen. “We have seen quite similar performance in alternative risk premia, which is coming back in this environment where central banks are not trying to keep the macro volatility low as they have done for over a decade.”
This article features in HedgeNordic’s Nordic Hedge Fund Industry Report.