Dec 2016 by Caroline Rasmussen
Equity markets are at near record highs despite muted earnings and growth, and fixed income markets are offering low and in some cases negative yields. In today’s volatile and frothy environment, investors should hedge their risk with uncorrelated investment strategies.
Equity markets are at near record highs despite muted earnings and growth, and fixed income markets are offering low and in some cases negative yields. In today's volatile and frothy environment, investors should hedge their risk with uncorrelated investment strategies.
North American public pension plans, which represent some of the largest institutional investors in the world, recently reported their returns for the 2016 fiscal year. The results are sobering—the nation’s two largest public plans, California Public Employee’s Retirement System (CALPERS) and California State Teacher’s Retirement System (CALSTRS) posted returns of just 0.6% and 1.4%, respectively.1
Both CALPERS and CALSTRS, along with many other US pension funds, have long term return targets of 7.5%.2 Research recently released by Callan Associates, which advises pension funds and other large investors, found that to earn a 7.5% return in 2015 investors would have had to allocate 63% to equities and could only invest 12% in bonds (with the remainder split between real estate and private equity).3 This compares to a 52% bond allocation and a 39% equities allocation in 2005 to achieve the same return (Figure 1). The key difference in these portfolios is the level of volatility, the traditional proxy for risk – while the 2005 portfolio exhibited a standard deviation of 8.9%, the 2015 portfolio had a standard deviation of over 17%.4 Further illustrating how much more risk an investor must take today to achieve the same returns that were available in higher interest rate environments, the research shows that in 1995 an investor could have allocated 100% of their portfolio to bonds to generate the same 7.5% return.
Callan’s analysis is a striking demonstration of how record low interest rates globally are causing investors to allocate away from bonds, traditionally viewed as relatively conservative investments, and take on far more risk to achieve the same results, which, in a historical context, are relatively modest. The concern with this approach is not only the inherent increase in volatility that one would expect with such a shift, but the fact that equities are at a cyclical high today and widely considered to be overpriced, with the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite Index all closing at record highs twice in August, an occurrence that has not happened once since 1999.5
At the modest 12% allocation identified by Callan for the 2015 model portfolio, bonds would not be able to provide meaningful downside protection, one of their traditional roles in a portfolio, albeit one that has become less pronounced in recent years. For instance, in 2002, safer corporate bonds returned about 11%, while U.S. stocks fell roughly 22%, according to a Segal Rogerscasey analysis of the Russell 3000 stock index plus historical bond returns tracked by Barclays and Citigroup.6 During the 2008 crisis, stocks fell more than 37% and higher-quality bonds declined 3.3%, according to the Segal Rogerscasey analysis. More recently, those types of bonds fell during the stock-market tumbles in August and December 2015. As described by Tom Girard, Senior Managing Director and Head of Fixed Income Investments at New York Life Insurance Company, "I can't just reach out and grab a high-quality bond that’s yielding 6% or 7%. They don't exist."7
In a world where bonds no longer provide the same level of return or risk protection that they have historically, and where general asset inflation has led to a frothy market for equities with elevated levels of volatility, investors should take a fresh look at uncorrelated, risk mitigating investments. A Preqin survey of institutional investors found that almost half (46%) of investors surveyed use hedge funds to dampen portfolio volatility, with 30% citing the mitigation of risks in other areas of their portfolio as a key objective of their hedge fund allocations.8 The key point to note is that most investors use hedge funds to maintain return, while reducing risk. As stated by the CIO of CALSTRS, who recently created a new allocation called "Risk Mitigating Strategies" targeted to be 9% of the pension fund’s portfolio, "We have a very large bias to growth in GDP in our portfolio. We want to hedge that. We actually want the hedge fund strategies not for extra return, we are doing the opposite. We think that they actually can be a defensive strategy."9
Hedge funds on average are less volatile than the market, which intuitively makes sense because they hedge their risk. Figure 2 depicts the loss-making periods suffered by hedge funds and the S&P from May 2008 to April 2014, showing that the equities index has seen both more instances of drawdown and more severe drawdowns than hedge funds over this period. Figure 3 shows how hedge funds can contribute to improved risk-adjusted returns in a broader portfolio by plotting various hedge fund investment strategies along the risk-return spectrum relative to the S&P 500.
In addition to the potential for lower volatility and better risk-adjusted returns than pure equities, hedge funds’ ability to produce returns that are uncorrelated to the equity markets has long been a cornerstone of their appeal, with 59% of institutional investors citing this as a key reason for their hedge fund investments.10 Because they employ derivatives, short sales and other techniques not available to most mutual funds and other public market investors, hedge funds tend to have correlations of less than 1 (which would indicate perfect correlation) with broad stock market indices.11 As of June 30, 2016, the Credit Suisse Hedge Fund Index had a correlation of 0.57 to the S&P 500.12
But importantly, correlation with stocks varies by hedge fund strategy. Figure 4 sets forth correlation coefficients for specific hedge fund strategies relative to traditional equities and fixed income.13 Relative value hedge funds (which seek to exploit differences in the price or rate of similar securities, rather than betting on the prices of individual securities) and macro hedge funds (which take positions across markets including equities, fixed income, currencies, commodities and futures on the basis of the firm’s macroeconomic and geopolitical views) offer significant diversification against equities. Macro strategies in particular have exhibited low correlation to equities during periods of stress, such as during the height of the financial crisis.14 In addition, all hedge fund strategies presented have low or negative correlations to traditional fixed income. Figure 5 plots correlations for primary hedge fund investment strategies along a spectrum relative to the S&P 500.
Hedge funds have historically contributed positively to the return-risk profile of traditional stock and bond portfolios. With equity and bond markets at their current levels, it makes sense to think defensively and seek low volatility, uncorrelated sources of return that help hedge portfolio exposure to the public markets. Certain hedge fund strategies may be more effective at achieving these objectives, namely those that have the lowest correlation to traditional equity and bond markets, such as global macro funds. However, even strategies with high correlation to the markets can add value depending on the market environment; long/short hedge funds outperformed equities through the bear market in 2009.15
Fundamentally, it is important to think not only in terms of returns, but risk-adjusted returns. For example, during the bull market from January 1994 to September 2000, market neutral hedge fund strategies underperformed the S&P 500 in annualized return, but outperformed in risk-adjusted terms, incurring less than one-fourth the risk of the index.16 In a world where fixed income yields are expected to remain lower for longer and public equity allocations need to be significantly ramped to achieve the same level of historical return, investors should consider judiciously adding hedge funds to mitigate risk in their portfolios.
Investments in hedge funds are speculative and risks include, among other things:
(i) loss of all or a substantial portion of the investment due to leveraging, short-selling, use of derivatives or other speculative practices,
(ii) incentives to make investments that are riskier or more speculative due to performance based compensation,
(iii) lack of liquidity as there may be no secondary market for hedge fund interests and none is expected to develop,
(iv) volatility of returns,
(v) restrictions on transfer,
(vi) potential lack of diversification and resulting higher risk due to concentration,
(vii) higher fees and expenses associated that may offset profits,
(viii) no requirement to provide periodic pricing or valuation information to investors,
(ix) complex tax structures and delays in distributing important tax information and
(x) fewer regulatory requirements than registered funds.
These risks are not inclusive of all risks related to hedge fund investments. Past performance is not an indication of future results.
(2) Calpers Earns 0.6% as Long-Term Returns Trail Fund’s Target, Bloomberg, John Gittelsohn, July 18, 2016, http://www.bloomberg.com/news/articles/2016-07-18/calpers-largest-u-s-pensionfund-earned-0-6-last-fiscal-year; CalSTRS Gains 1.4% in Fiscal 2015-16, Pension360, Leo Kolivakis, http://pension360.org/calstrs-gains-1-4-in-fiscal-2015-16/.
(3) Pension Funds Pile on Risk Just to Get a Reasonable Return, Wall Street Journal, Timothy Martin, May 31, 2016.
(4) Pension Funds Pile on Risk Just to Get a Reasonable Return, Wall Street Journal, Timothy Martin, May 31, 2016.
(5) Stocks close at record highs as oil rallies, MarketWatch, Wallace Witkowski & Anora Mahmudova, August 15, 2016, http://www.marketwatch.com/story/us-stock-futures-inch-higher-ahead-of-empire-state-reading-2016-08-15.
(6) Pension Funds Pile on Risk Just to Get a Reasonable Return, Wall Street Journal, Timothy Martin, May 31, 2016.
(7) Pension Funds Pile on Risk Just to Get a Reasonable Return, Wall Street Journal, Timothy Martin, May 31, 2016.
(8) Investing in Hedge Funds: All About Returns? The Real Drivers for Institutional Investor Allocation, Preqin, June 2014. The results of this study are based on a Preqin survey of over 100 investors conducted in April 2014, with these investors representing more than $13tn in assets under management. The investors were located globally and represented a broad spectrum of investor types from the largest pension funds, through to family offices and other private wealth institutions. Additional data was taken from Preqin’s Hedge Fund Online service, which maintains data on over 4,600 investors in hedge funds, 16,500 hedge funds and 6,700 fund managers.
(9) Hedge Funds May See Up To $8.7 Billion Windfall From Calstrs, Bloomberg, Klaus Wille, September 14, 2016, http://www.bloomberg.com/news/articles/2016-09-14/hedge-funds-may-see-up-to-8-7-billion-windfall-from-calstrs.
(10) Investing in Hedge Funds: All About Returns? The Real Drivers for Institutional Investor Allocation, Preqin, June 2014. The results of this study are based on a Preqin survey of over 100 investors conducted in April 2014, with these investors representing more than $13tn in assets under management. The investors were located globally and represented a broad spectrum of investor types from the largest pension funds, through to family offices and other private wealth institutions. Additional data was taken from Preqin’s Hedge Fund Online service, which maintains data on over 4,600 investors in hedge funds, 16,500 hedge funds and 6,700 fund managers.
(11) A correlation coefficient of 0 would indicate no correlation, while a coefficient of less than 0 would indicate negative correlation / that the two variables tend to move in inverse directions. Revisiting the Role of Alternatives in Asset Allocation, Prudential Global Investment Management, Harsh Parikh & Tully Cheng, 2016.
(12) iCapital, Credit Suisse.
(13) US Aggregate is measured using Barclays US Aggregate Index; World Equity is measured using MSCI ACWI Gross Returns; Global Aggregate is measured using the Barclays Global Aggregate Index.
(14) S&P, 3 year rolling correlations of HFs, Jan 2000 – March 2015. Revisiting the Role of Alternatives in Asset Allocation, Prudential Global Investment Management, Harsh Parikh & Tully Cheng, 2016.
(15) Eureka Hedge L/S Equities Index, Hedge Fund Bloodbath Led By Long-Short Outflows, Fundfire/Bloomberg, http://www.bizjournals.com/bizjournals/video/44ZmFlNTE6_pVcnFIwMxHaOKsNzCin5Z?autoplay=1.
(16) CSFB/Tremont analysis. Hedge Funds: Higher Returns or Just High Fees?, Investopedia, David Harper.
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