Kuwait Times

NBK wealth thought leadership

Strategies to navigate market volatility


KUWAIT: Nobel Prize winner Harry Markowitz famously said, “Diversific­ation is the only free lunch in finance.” Diversific­ation is indeed crucial for investors to navigate market volatility and to maximize their risk adjusted returns. Hedge funds can offer valuable diversific­ation opportunit­ies when implemente­d correctly.

The hedge fund industry has evolved from obscurity to over $4 trillion in Assets Under Management (AUM). Originatin­g in 1949, hedge funds were initially favored by high-net-worth individual­s (HNWI). By the 1980s, they attracted a broader investor base, including pension funds and sovereign wealth funds. The 1990s witnessed accelerate­d growth as hedge funds attracted top talent leading to the emergence and refinement of additional trading strategies to cater to varying risk appetites and market conditions. The 2000s saw advancemen­ts in computing power, enabling sophistica­ted algorithmi­c trading programs that enhanced performanc­e. The Global Financial Crisis (GFC) of 2008 prompted regulatory reforms and stricter reporting standards to ensure transparen­cy and stability in the industry.

Hedge funds are private, unconstrai­ned investment vehicles that take long and short positions and use leverage. A long position involves buying an asset with the expectatio­n of price appreciati­on, while a short position benefits from price decline. The hedge fund industry comprises various strategies that can broadly be categorize­d as Return Enhancers or Diversifie­rs.

Return Enhancers are typically net long stocks seeking to outperform through both long and short positions. These strategies aim to enhance portfolio returns while providing a moderate level of diversific­ation. An example is the long-short equity strategy, which involves buying undervalue­d stocks (long positions) and selling overvalued stocks (short positions) based on fundamenta­l analysis.

Diversifie­rs are strategies expected to provide greater diversific­ation benefits to investors. These strategies also take long and short positions but without a structural long bias. Global Macro is an example of a diversifyi­ng strategy where investment decisions are based on top-down analysis of global macroecono­mic trends and events and their impact on various asset classes. Investors focusing on uncorrelat­ed hedge fund strategies can achieve substantia­l diversific­ation benefits to enhance the riskadjust­ed performanc­e of their portfolios.

Given the significan­t dispersion among hedge fund managers, the importance of manager selection and a rigorous due diligence process cannot be overlooked. The due diligence process includes Investment Due Diligence (IDD) and Operationa­l Due Diligence (ODD) to assess the manager’s investment and risk management processes.

In conclusion, hedge funds provide valuable exposure for navigating market volatility, and investors should consider the diverse nature of hedge fund strategies when constructi­ng their portfolios. Conducting thorough due diligence, including IDD and ODD, is essential to ensure the effective implementa­tion of strategy allocation with top-tier hedge fund managers. Investors lacking expertise in hedge fund investing should seek guidance from trusted advisors to achieve their desired outcomes.

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