Dec 2017 by Joe Burns
Hedge Funds have underperformed, so why do I need them in my portfolio?
The narrative around “hedge fund underperformance” should be taken with many grains of salt. Three immediate questions an advisor should consider when addressing that question should be: (i) underperformance relative to what (e.g. equity markets, other alternative strategies, investor expectations, etc.), (ii) over what timeframe are we evaluating comparative returns, and (iii) what are the historical (and prospective) drivers of performance for hedge funds in relation to other return sources in traditional and alternative asset classes.
Assessing broad hedge funds performance is quite challenging, as thousands of funds are spread across many uncorrelated investment strategies, and the inter-quartile spread between top and bottom quartile funds is far more significant in alternative strategies (e.g. private equity, private debt and hedge funds) than in traditional equity and fixed income markets. That said, one reference for “hedge fund performance” is the HFRI Fund Weighted Composite Index, a broad index that includes a large universe of hedge fund returns across multiple strategies. With available data going back to 1990, the below table depicts the comparative performance and volatility characteristics of the HFRI Index compared to the S&P 500 Index and Barclay Aggregate Index as proxies for equity and fixed income markets, respectively, segmented by four distinct 7-year periods1 :
A few key takeaways:
• During each period, hedge funds outperformed fixed income with less than half the volatility of equities
• During the first three periods (seven years ending Dec. ‘96, Dec. ‘03 and Dec. ‘10), hedge funds outperformed equities by 300-500 basis points on an absolute basis, and more significantly on a risk-adjusted basis
• Over the most recent period through Sep. 2017, hedge funds have underperformed equities considerably
While much has been written about the drivers of this relative underperformance, we believe that the most significant contributor has been the effects of historically low interest rates, quantitative easing and the global appreciation of risk assets at the broader index level. As the following chart shows, the 3-month Treasury Bill ranged from 3-5% for much of the 20-year period preceding the financial crisis, after which rates were effectively brought to zero.
One of the implications of this policy was an increase in cross-asset correlations and a lack of differentiation in security prices, fueling the rise of liquid, passive, long-only instruments. This trend, as it relates to interest rate increases and simulative central bank policies, changed in late 2015 (see bottom right area in the above chart), and has continued since, creating a much more conducive environment for those strategies that seek a wider dispersion of outcome in securities that rise and fall for more idiosyncratic reasons. While “long and strong” has been the best strategy over the past 7-8 years, history suggests that hedged strategies have delivered long-term outperformance.
Do Hedge Funds need the market to sell-off in order to outperform?
With equity markets approaching Year 10 of this historically advanced bull market, and with hedge funds having underperformed over much of that period, some investors are considering hedge funds only in the context of downside protection. While it is true that most hedged strategies outperformed equity markets substantially in 2000-2002 and again in 2008, with certain strategies delivering positive performance in one or both periods, when equities declined by (40-50%). Looking forward, it is critically important to understand the drivers of returns that underpin hedge fund strategies, as opposed to evaluating past performance in that context of a changing market environment.
As referenced above, the first three periods in Table 1 can each be categorized as “high, moderate, and low return” environments for U.S. equities, with the S&P 500 Index annualizing at roughly 14.4%, 7.6% and 3.9% over those distinct 7-year periods. Interestingly, while hedge funds outperformed in each period, the largest performance differential occurred during the 1990-1996 period, when the S&P 500 Index delivered mid-teens returns to investors, and hedge funds outperformed by 500bps. The worst of those three periods from a comparative performance standpoint was 2004-2010, with hedge funds generating 6.8% returns vs. the S&P 500 Index returns of just 3.8%. Interestingly, based upon previous periods of high/ low equity performance, hedge funds performed best when equities were up the most.
So, hedge funds outperformed during up markets, and protected capital in down markets, but have underperformed over the past 7 years. What then are the realistic expectations investors should have regarding future hedge funds performance relative to stocks and bonds? In short, most hedge fund strategies are not “short the market.” Instead, they are effectively short correlation and long dispersion, meaning that an era of extremely high correlation and low dispersion is the worst environment for most hedged strategies.
Throughout the 2009-2015 period, we saw a 7-year period of exceptionally high correlations (assets moving in near-lockstep) with historically low dispersions (narrower range of outcome). Since Dec. 2015 we have seen a nearly 2-year period of rising interest rates, first in the U.S. and more recently across the global, which has coincided with a precipitous decline in cross-asset correlations, as depicted by the following charts.
Effectively all hedge fund strategies require some level of price dispersion, benefitting from lower correlations within and across asset classes globally. While the 2009-2015 environment was dominated by Central Bank policies and various forms of quantitative easing, the past 2 years have seen a paradigm shift towards new return drivers. Unsurprisingly, the performance of many hedged strategies has picked up considerably over this period. Against the backdrop of “expensive” stocks and bonds, this differentiated performance serves an increasingly significant role within a diversified portfolio.
(1) The Jan. 2011 - Sep. 2017 period is 6.75 years, and includes the most recent performance available at the time of this analysis