Mar 2019 by Joseph Burns & Aref Jessani
An overview of the evolution and importance of Hedge Fund strategies
Global hedge fund assets increased once again in 2018, surpassing $3.0 trillion in aggregate capital for the first time. Over the trailing five years, hedge fund assets have increased by over $1.0 trillion as investors continually seek out investment strategies designed to protect against increasing market volatility. More recently, investors have also been focusing on select hedge funds to help drive portfolio performance, following a nearly 10-year bull market in global equities.
This increase in assets comes at a time when hedge funds – and active investing generally – have been under pressure as compared against U.S. equity index returns. While hedge funds have lagged long-only equities for much of the post-crisis period on an absolute returns basis, the average hedge fund return has tended to exceed that of a traditionally constructed global portfolio consisting of long-only equities and fixed income securities.
Following a robust 2017, when each of the broad hedge fund investment strategies generated positive performance, returns declined across-the-board in 2018. None of the broad hedge fund strategies generated positive performance although most outperformed the global 60/40 index. For the overall hedge fund industry, the composite performance was the worst on record since 2008.
Nevertheless, given the challenges facing traditional equities and fixed income in 2018,1 the long-term outperformance of a representative hedge fund as compared to U.S. and global stocks, bonds and a traditional "60/40" portfolio remains intact, with available data going back to 1990.2
Of course, referencing "hedge fund performance" as a single number presents myriad challenges, including the diverse mix of strategies, varying risk/return profiles and the post-crisis proliferation of "mega funds”.3 For instance, Hedge Fund Research (HFR) reports that the number of hedge funds in operation total 8,389.4 Additionally, HFR reports that the Largest 100 Hedge Funds collectively manage $1.75 trillion of the total $3.21 trillion in aggregate assets, representing 54% of total industry-wide assets. Stated another way, roughly 1% of the hedge funds today manage over half of the industry's total assets under management. While a percentage of those Funds could undoubtedly bene t from increased scale – e.g., quantitatively-oriented, global multi-asset class firms that require more people and processing power – there are many more funds that struggle following a significant uptick in their asset base, particularly those with a focus on off-the-run, less liquid securities. These strategies very often benefit smaller and mid-sized funds, vs. their much larger peers.
Another factor that makes the evaluation of "hedge fund performance " so challenging is the significant level of interquartile spread strategies. In 2018, for example, there was an approximately 16% differential between top quartile (+5%) and bottom quartile (-11%) funds performing funds based on HFRI data. Even those strategies that tend to have less dispersion, such as credit and relative value, saw the best-performing funds outperform the laggards by 6%-10% in 2018 alone. As is always the case with alternative investment strategies, manager selection is critically important.
While the average hedge fund outperformed equity markets and a global "60/40" portfolio last year, performance was still generally disappointing for most active fund managers. Historically, actively managed hedge funds have tended to provide significant outperformance during the latter stages of an economic cycle. As shown in the following chart, the rolling 2-year returns of the HFRI Fund Weighted Composite Index surpassed the performance of the MSCI World Index in the early ’90s, in the early ’00s, and again in 2009 by an average of 20%, with relative underperformance more recently.5
One contributing factor relating to the historical outperformance of actively managed hedge funds often corresponds with the level of interest rates. While the 4th quarter of 2018 represented the 10-year anniversary of the Global Financial Crisis, it also marked the first time in 10+ years that the Fed Funds Rate exceeded 2%, as referenced in the following chart. The primary challenge for hedged strategies in a low / zero interest rate environment is a lack of dispersion across stocks, bonds, and many investment securities. 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 much of the post-crisis period, we saw an extended period of exceptionally high correlations (assets moving in near-lockstep) with historically low dispersions (narrower range of outcome). In such an environment, long-only strategies have tended to outperform since most hedge fund strategies require some level of price dispersion, benefiting from lower correlations within and across asset classes globally. While the trailing ten years have been dominated by interventionist policies and various forms of quantitative easing, more recently we have seen a shift towards new return drivers and the performance of many hedged strategies has improved. From a fundamental perspective, at zero interest rates and ample market liquidity, the majority of global companies can easily refinance their debt and restructure their balance sheets, ostensibly “kicking the can down the road.” However, with higher rates and a tougher lending environment, the available options for lower quality companies diminish, which can lead to a widening gap in performance of individual investments across bonds, stocks, sectors, and global markets.
Another benefit for hedged strategies relates to changes in the macroeconomic cycle. For example, during the “peak/growth” phase the top-performing securities are very often long-only risk assets, e.g., stocks and high yield bonds. Compare that to the opportunity set as markets contract, when active management in relatively complex situations can lead to substantial outperformance over time in many event-driven and credit-based strategies.
Typically, the most robust Event-Driven strategy during the latter stages of an economic cycle is merger arbitrage, as companies look to grow strategically in anticipation of a decline in their organic growth prospects. As demonstrated on the chart below, deal activity for U.S. mergers remains relatively strong, albeit having contracted from its recent peak in 2015. Conversely, this compares to a dearth of opportunities for distressed specialists, with the default rate still hovering around half its long-term average and historically tight high-yield spreads. Even within specific hedge fund strategies such as Event Driven, the divergence of opportunities is often quite varied, particularly in the latter stages of an economic cycle.
The primary drivers for utilizing hedged strategies within a diversified portfolio are the increasing volatility in traditional equity markets, and investor expectations of future risk-adjusted equity performance. The increases in the Federal Funds rate over the past few years have demonstrated how the post-Financial Crisis era of zero-percent interest rates has come to an end. This policy shift has coincided with the end of quantitative easing strategies globally, and the Federal Reserve has initiated its process of actively seeking to reduce its balance sheet. This combination has resulted in rising investor concerns about a potential economic slowdown, and a reduction in investor expectations for future equity performance, leading to an uptick in global market volatility.
Though equity volatility has been compressed for much of the past ten years, multi-year periods of elevated volatility can be tied to factors such as global policy changes, market liquidity, investor sentiment, or security prices that can be seen as potential leading indicators. For example, the following chart depicts the "flattening yield curve"6 juxtaposed to the historical level of volatility, as measured by the VIX Index. This highlights the historical relationship of a narrowing spread between the short and long-end of the Treasury curve as a leading indicator of increasing equity market volatility. Assuming that the spread between short and long-duration bonds remains relatively tight, one can expect the recently realized increase in market volatility to remain a factor that advisors must consider when constructing and adjusting client portfolios.
There is no shortage of factors to keep investors on "high alert" these days including, changes in the global economy, heightened volatility in equity markets, and a lack of alpha generation amongst certain alternative strategies, particularly during periods of elevated asset class correlations. Looking ahead, Advisors must remain vigilant in providing their clients with access to diversified sources of return, portfolio diversification, and consistent wealth preservation. Complementary hedge fund strategies can provide access to each of those portfolio objectives, ideally executed through a combination of (i) smaller or larger funds, (ii) sector specialists or multi-asset generalists, (iii) fundamental or quantitative techniques, and (iv) long-only or long/short investment strategies. Through pre-defining each hedge fund investment’s long-term role in a diversified portfolio - and choosing the best strategy and style for its primary objective - Advisors can beneficially utilize multiple hedge fund investments to improve the overall quality of the clients’ portfolios.
(1) The MSCI World Index was down (8.7%) in 2018, and the Bloomberg Barclays Global Aggregate Bond Index was down (1.2%). Source: Evestment
(2) As referenced by the HFRI Fund Weighted Composite Index
(3) Hedge funds with at least $5 billion in assets under management
(4) Source: Hedge Fund Research, Inc. As of Sep. 30th, 2018
(5) For the 2-year period ending Dec. 31st, 2018 the HFRI Fund Weighted Composite Index underperformed the MSCI World index by less than 4%
(6) As measured by the yield of the 10-year U.S. Treasury Bond minus the yield on the 2-year Treasury Note
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