Jul 2018 by Joe Burns
iCapital’s Head of Hedge Fund Due Diligence, Joe Burns, discusses five key considerations for hedge fund investors and takes a closer look at recent performance, the potential role hedge funds can play in downside protection and outperformance, managing illiquidity and transparency, and finding the right fund for your investment objectives.
The narrative around “hedge fund underperformance” should be taken with a grain 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 fund 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 fund) 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, Table 1 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 Dec. 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 Table 2 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 stimulative central bank policies, changed in late 2015 (see bottom right area in Table 3) 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 idiosyncratic reasons. While "long and strong" has been the best performing strategy over the recent past, long and short strategies have delivered absolute and risk-adjusted outperformance over the long-term.
With equity markets approaching Year Ten of a historic bull run, 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 (dot-com bubble popped) and again in 2008 (the financial crisis)— with certain strategies delivering positive performance in one or both periods when equities declined by 40%- 50%—it is critically important to understand the drivers of return that underpin hedge fund strategies, as opposed to setting return expectations based solely on how they performed during those extreme market environments.
As referenced in Table 1, the first three periods can 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 fund performance relative to stocks and bonds? Essentially, 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 mid-2016, we have seen a 2-year period of steadily rising interest rates, first in the U.S. and more recently across the globe, leading to stronger performance for many long/short investment strategies.
Investors might wonder why rising rates correspond with declining correlations, leading to an improved market for hedge funds. When rates are low (or zero), a few things happen: companies can easily re nance their debt, so the risk of a bond default or a fundamental decline in earnings is minimal since management can simply “borrow their way out of trouble.” In such an environment stocks and bonds generally rise (with few exceptions) and lower quality securities appreciate the most as investors continually get pushed out on the risk curve to drive returns higher.
In such an environment, long-only strategies will always outperform—since most 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 interventionist policies and various forms of quantitative easing, the past two years have seen a paradigm shift towards new return drivers and 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.
Both stocks and bonds have several sources of return, which over the long-term provide a reasonable guide to future performance. For equities, one must consider valuation and growth: valuation in terms of margin and multiple expansion, and growth in the context of potential earnings and dividend appreciation. Bonds are a bit more straight- forward, as investors must consider the credit worthiness of an issuing entity (the likelihood of a bond maturing at par), along with the coupon payment as a form of current income. From a macro point of view, capital flows and technical factors can dominate the price movements of both bonds and equities over reasonable periods.
Table 4 reflects (i) the underlying components of equity returns, as presented in a recent GMO article referencing the forward-looking return expectations of the S&P 500 Index, and (ii) the expansion of the U.S. Federal Reserve (Fed) balance sheet since the onset of Quantitative Easing (QE).
While the growth in earnings and dividends for S&P 500 constituent companies has been relatively steady over the past 50 years, the more variable components of re- turn are related to valuation, specifically multiple (price/ earnings) and margin (income/revenue) expansion, or contraction. It is widely understood that current equity valuations are at extreme levels, with the cyclically-adjusted P/E ratio of the S&P 500 currently trading above 30, which had only occurred in the late 1920’s and 1990’s, prior to the most significant equity declines in U.S. market history. Per the analysis above, the expected return for the S&P 500 over the next seven years is -3.9% (annualized), assuming valuation levels ultimately revert to their historical norms over that period. While this seems excessive, it is interesting to note that the 7-year annualized return for the S&P 500 Index through March 2009 was -3.2%.
Anticipating negative returns for equities over the next seven years is di cult to fathom, especially after the S&P 500 Index has generated an annualized 18% return since 2009. But, as mentioned previously, it is also important to consider how broader macro factors may have contributed to this exponential rise in equity (and bond) prices, and how they may play into future performance expectations.
In our view, the most significant macro factor in recent memory has been the unprecedented monetary policy of Central Banks enacted in response to the 2008 financial crisis. As seen in Table 5, the Fed has increased its balance sheet by ~$4 trillion since 2009, from ~$500 billion to ~$4.5 trillion.
This $4 trillion increase was the result of the Fed purchasing enormous amounts of Treasuries and mortgage-backed bonds. Their intent was to pump liquidity into the markets and drive bond prices higher (and correspondingly, bond yields lower), which, in turn, made the earnings yield of equities appear that much more attractive when com- pared to a 10-year Treasury yield of sub-2%.
The Fed announced the end of QE and its intent to normalize monetary policy in 2017. As they continue the pro- cess of raising interest rates and reducing the size of their balance sheet, this substantial driver of asset price appreciation will no longer be the primary engine of bond and equity markets. While both asset classes benefited tremendously from this multi-year tailwind, so too might stocks and bonds struggle as liquidity gets slowly and steadily pulled out of the financial system. This will not only create problems from a (lack of) diversification standpoint but will impact the most significant return driver in most portfolios: global equity market appreciation. The importance of portfolio diversification, moving further away from the traditional allocation model of only stocks and bonds, increases daily.
The liquidity of a hedge fund investment and the level of transparency available to investors will vary by investment strategy and from fund manager to fund manager. The key for investors is to assess the liquidity of their overall port- folio, with the ability to make informed decisions via access to detailed market-level information and fund-specific due diligence that certain advisory firms can provide. Accessing high-quality, high-performing funds that are comparatively liquid and transparent can result in higher returns, and improve risk-adjusted performance over the long term.
When thinking about hedge fund liquidity, it is first helpful to view it on a spectrum relative to other assets [Table 6]. Cash and cash equivalents sit on the highly liquid end, while alternative investments like hedge funds, private equity, and venture capital investments are on the highly illiquid end. Hedge funds tend to be less liquid than stocks, bonds, and most mutual funds, but more liquid than private equity, venture capital, real estate, or other highly illiquid investments.
Next, in Table 7 we look at the relative liquidity profiles of different hedge fund strategies. It is interesting to note that the relative liquidity of different hedge fund strategies tends to align with the liquidity of the underlying assets they primarily invest in.
For example, managed futures managers tend to be one of the most liquid hedge fund strategies and they trade instruments in large, highly liquid markets. Event-driven strategies, which tend to hold large, concentrated, less liquid positions while waiting for an anticipated event to occur, tend to be a less liquid hedge fund strategy.
While the level of transparency can vary by fund manager and strategy, at a minimum, investors need to ensure they have a handle on the primary return drivers and risk factors related to the investment strategy, as well as the operational capabilities of each rm, before investing. These can be analyzed both qualitatively and quantitatively.
From a qualitative perspective, investors should understand the instruments being used to pursue the strategy (stocks, bonds, currencies, derivatives, etc.) and how the portfolio is constructed. This includes understanding specific holdings (where applicable), position sizing; regional, sectoral and stylistic composition of the fund; and the liquidity, concentration, leverage, and complexity of the overall strategy.
Quantitatively, beyond a simple assessment of historical returns, investors should feel comfortable with risk-adjusted performance profile relating to their pre-investment and forward-looking expectations. This includes an analysis of realized volatility, drawdown potential (ex-ante and ex-post), market beta (dependency on broader markets driving returns), correlation with other holdings within their portfolio, and contribution to returns from alpha, or manager-specific performance above and beyond a relevant benchmark.
When assessing the operational capabilities of the firm, investors should focus on evaluating the internal policies and procedures, pricing and valuation methodologies, and commitment to institutional best practices at both the fund and rm level. Additionally, they should review the third-party service providers to ensure they are working with top-tier organizations. Too often investors rely upon realized performance and extrapolate future returns when making an investment decision. Drilling into the sources of return, the statistical robustness of the performance and the strength of each rm’s operational business processes is as important, and likely more predictive in assessing the future impact of each investment within a diversified portfolio.
Evaluating "hedge funds" in the context of a diversified portfolio is fundamentally challenging, mainly due to the widely disparate investment strategies, liquidity profiles, and distinct risk/return characteristics. Experienced hedge fund investors understand the different drivers and portfolio utility when allocating to multi-strategy, long/short equity, hedged credit, event-driven, discretionary macro and systematic trading funds. While the sub-strategy allocation is undoubtedly important, the more vital question is: what am I looking to solve for in the context of my overall portfolio? Specifically, am I looking for a hedge fund to provide capital preservation, portfolio diversification or, higher returns.
• Capital Preservation: This desire was described 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."2 This approach is often focused on larger established funds that trade in many different markets, and dynamically deploy capital amongst multiple strategies across the capital structure. These funds can offer investors capital protection while still delivering strong risk-adjusted returns over time.
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 fundamental objective of their hedge fund allocations.3 Table 8 depicts the loss-making periods suffered by hedge funds and the S&P from May 2008 to April 2013, showing that the equities index has seen more instances of drawdown and more severe drawdowns than hedge funds over this period.
• Portfolio Diversification: As noted above, Preqin found that almost half of institutional investors use hedge funds to dampen portfolio volatility. The primary method to do this is through portfolio diversification, using hedge fund strategies that carry a minimal (or negative) correlation to traditional markets. As the Table 94 indicates, global macro strategies and systematic trading strategies have consistently shown the minimal (or negative) correlation to traditional markets. Following the recent period of uncommonly strong long-only performance, these strategies have unsurprisingly lagged, but o er investors an opportunity to diversify their risk and introduce new return drivers long-term.
• Return Enhancement: There are three primary ways in which an investor can achieve enhanced returns via hedge funds, and all seek to take advantage of the flexibility that hedge funds have over their mutual fund rivals. The first is where the hedge fund has a distinct focus be it geographical, sectoral or factor-based (e.g., value-biased) and the manager has the right skill-set and network to pro t from this experience. For example; a value-orientated manager requires a long time horizon and a very in-depth research process, as it is likely to run a concentrated portfolio with a net long-bias. These funds can show mark-to- market volatility, but over time the ultimate returns will predominantly come from idiosyncratic risk (i.e., stock-picking) rather than market risk.
Coinvestments are the second way of enhancing returns, allowing investors to participate alongside a hedge fund in a single investment idea.
Finally, investors seeking to enhance returns should focus on accessing emerging funds that historically have delivered outperformance vs. larger peers. Strategically, these managers tend to focus on fundamentally-driven long/ short equity and event-driven strategies. Emerging funds can outperform their larger counterparts due to:
- A better opportunity set: Emerging managers are less constrained by liquidity and can invest across the market capitalization spectrum. This allows them to invest in smaller stocks but also to take larger positions (liquidity may the limiting risk factor for a large fund looking at the same investment).
- Talent: The best managers self-select, starting their own firms after building experience at a larger firm.
- Motivation: Many motivational factors help drive smaller managers to focus on returns; their limited asset base means the performance fee represents the majority of their profit; the entrepreneurial desire to ‘make it’ can be a driving factor; and the small size of the team means that the founder is more intimately involved with all aspects of the 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
(2) 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
(3) 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.
(4) 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.
This material is for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security described herein. Any such offer or solicitation shall be made only pursuant to the fund’s confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein.
Past performance is not indicative of future results. Products offered by iCapital are typically private placements that are sold only to qualified clients of iCapital through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder ("Private Placements"). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described involve long lock-ups and do not provide investors with liquidity.
Private placements, particularly private equity funds, have important differences from public markets, are speculative and include a high degree of risk. Certain of these risks may include but are not limited to:
• Loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices; • Lack of liquidity in that there may be no secondary market for a fund;
• Volatility of returns;
• Restrictions on transferring interests in a fund;
• Potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized;
• Absence of information regarding valuations and pricing;
• Complex tax structures and delays in tax reporting;
• Less regulation and higher fees than mutual funds; and
• Risks associated with the operations, personnel, and processes of any fund’s manager
The information contained herein is confidential, the property of iCapital Network, and only for intended recipients and their authorized agents and representatives and may not be reproduced or distributed to any other person without prior written consent. The information contained herein is also subject to change and is incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital Network assumes no liability for the information provided. This information is the property of iCapital Network. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. (d/b/a iCapital Network). These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. iCapital is a registered trademark of Institutional Capital Network, Inc.
Additional information is available upon request.