In today’s uncertain and ever-changing market environment, there are many factors for hedge fund investors to consider. Nevertheless, hedge funds remain a crucial part of asset allocation and have historically delivered attractive risk-adjusted returns relative to other asset classes.
The value proposition for hedge funds is stronger than it has been in recent years. Indeed, the long-term case for hedge funds is supported by how they have performed historically versus other traditional asset classes in both normal and volatile market periods. Hedge funds represent a value proposition in our low-yield, low-interest-rate environment, and play an important role in a diversifier.
The Power Of Compounding
Historically, hedge fund performance has compared favorably to other asset classes. Hedge funds (as measured by the HFRI Fund Weighted Composite Index FWC) have been able to outperform both equity (as measured by the S&P 500 index) and fixed income (as measured by the Barclays Aggregate Bond Index) markets over time with half the volatility of equity markets. By outperforming equities in extreme markets—the markets of 1987, 2001, 2002, 2008—hedge funds have delivered attractive returns over various market cycles (Figures 1 and 2).
Hedge funds generally focus on producing alpha—returns not attributable to the performance of broader markets. In order to do this, hedge funds generally look to hedge certain market risks they do not want to take, thus isolating the risks and potential rewards of trades they are looking to capture.
Hedging (equity market risk, interest rates, etc.) can be difficult in calm, rising markets, but it is imperative when markets become volatile, which can occur unexpectedly. This is demonstrated when examining hedge fund performance versus stocks in down markets, such as during the financial crisis of 2008. By hedging out invested risks, hedge funds hope to preserve capital in difficult market environments.
Hedge funds have preserved capital in difficult months due to effective risk management and hedging strategies, while long only or buy-and-hold strategies are more directional as they are benchmarked to traditional indices.
Why does this matter? Because hedge funds have been able to limit losses in difficult market periods such as 2008 and have been able to outperform over a longer period despite underperforming equities in more bullish markets, such as in 2009 (Figure 3). This illustrates the power of compounding; in difficult periods, for many strategies, positive returns are not practical, but preservation of capital will build wealth over time.
Lower Yields, Improving Fundamentals
The value proposition for hedge funds is as attractive as ever. Despite rallying equity markets, global macroeconomic uncertainty remains. In this environment, hedge funds can add significant value to a portfolio by adding a diversified source of returns.
Low Yields: Interest rates have reached historically low levels, leaving investors with few options to generate attractive real returns without drastically altering the risk profile of their portfolio. In the current low interest-rate environment, hedge funds can help mitigate risk and play a valuable role in helping to improve overall portfolio risk/reward.
Low Correlation: In light of this low- yield environment, hedge funds have displayed low to negative correlation to fixed income during virtually every market cycle. This offers investors an attractive option for portfolio diversification.
Attractive Investment Environment: Increasing levels of corporate activity and decreasing levels of intra-stock correlation bode well for hedge funds’ ability to generate alpha. Macro headwinds caused by the 2010 flash crash, uncertain central bank policy and issues in Europe caused stock correlation to reach historic levels. High intra-stock correlation was a detriment to fundamental strategies that provide alpha through idiosyncratic security selection. However, the last year has seen a material drop in intra-stock correlations—typically a better environment for hedge funds.
Additionally, merger and acquisition (M&A) volume is beginning to recover after falling sharply in 2008 and 2009. Deal volume in fourth quarter 2012 reached its highest level since 2008. Meanwhile, cash on corporate balance sheets has been increasing steadily, opening up the possibility of a continued increase in M&A. There has also been large deal activity in the first half of 2013. This activity is a positive for hedge fund strategies, including equity long-short and equity event-driven strategies.
Improving Relative Return
One of the biggest concerns investors have regarding hedge funds is their recent history of underperformance. While it is true that hedge funds have generally lagged equity and bond markets in recent years, performance has improved in recent months. Hedge funds have demonstrated an ability to preserve capital in difficult market environments and provide upside capture in positive equity markets.
Hedge funds, as measured by the HFRI Fund Weighted Composite Index, have outperformed fixed income in eight of the last 12 months, from July 2012 through June. Cumulatively, hedge funds outperformed fixed income by over 900 basis points (bps) during this period. Hedge funds have also demonstrated the ability to preserve capital in difficult equity markets. When compared with equities in the fourth quarter of 2012, hedge funds were up over 1% while the S&P 500 TR Index was down about 40 bps.
A Diversified Portfolio
Hedge funds have historically been discussed as a homogeneous asset class. However, they should be diffused into a wide range of varying exposures and strategies. Different hedge funds serve different purposes in client portfolios vis-à-vis stocks and bonds and need to be positioned appropriately. Some are designed to enhance returns, others to dampen volatility, while some strictly strive to provide diversification.
Hedge funds can be broken down into three categories:
Volatility dampeners have low to moderate correlation with traditional markets and seek low volatility and consistent bond-like returns. These managers attempt to eliminate a substantial portion of market risk via hedges and trade construction.
Diversifiers are funds that typically display low or negative correlation to traditional asset classes, though they may display significant market correlation at certain points in the investment cycle. These funds generally provide attractive diversification benefits to a portfolio, though returns are often unpredictable.
Return enhancers generally seek to outperform traditional risk assets over the course of an investment cycle while still providing some measure of downside protection. These managers have a higher correlation and beta to traditional markets.
It is important to note that not all funds will perform well in all environments—choosing the appropriate strategy is the key. Hedge funds have historically provided diversification and can help improve the risk/return profile of a portfolio. However, depending on a specific investor’s objective and risk profile, advisors typically recommend a 10% to 25% allocation to hedge funds in a diversified portfolio.
Industry Changes
The financial industry suffered significant losses in 2008 due to extraordinary events, including a credit and liquidity crisis and fraud that shook financial markets worldwide. The hedge fund industry, however, emerged in a stronger and more robust position to adjust to new demands from both regulators and investors. Thus, they have become more institutional in nature and have adopted several significant changes that help safeguard investors:
Increased Transparency: Investors are demanding increased transparency into managers’ exposures and positions as well as organizational transparency.
Focus On Liquidity: In 2008, many managers suffered from their inability to sell positions as investors redeemed, forcing many hedge funds to suspend redemptions or side-pocket their most illiquid positions. As a result, managers today are generally more mindful of the underlying liquidity of positions as well as what types of investors hold the same instrument (i.e., is a trade crowded with investors who might exacerbate negative price movement in a crisis?)
Since the crisis, many hedge funds have adjusted their redemption and leverage terms. In addition, many managers have introduced an investor-level gate, limiting the amount any investor can take out at any one redemption period, thereby decreasing the potential for a run on the fund.
Deleveraging: Leverage is no longer as widely or aggressively used in the industry. Prior to 2008, many managers sought higher returns by using cheap financing and levering uninteresting returns.
Fostering A Compliance Culture: Hedge funds have had to fortify their compliance policies, procedures and personnel in response to the dynamic regulatory environment that has emerged since 2008. Increased regulatory oversight and the use of independent administrators should help protect investors from fraud and allow the industry to follow best practices.
Operational Streamlining: Amid growing investor pressure to reduce fees, many hedge funds will increasingly turn to outsourcing, process, efficiencies, enhanced data management and numerous technology solutions to help alleviate the operational strains that impact costs.
In closing, the hedge fund industry has endured a tumultuous period over the past several years. Heightened market volatility and growing global macroeconomic uncertainty were among the many factors that challenged hedge funds in the recent past. Nevertheless, there are reasons to be optimistic about hedge fund investing in 2013.
With interest rates at historically low levels, leaving investors with few options to generate real returns without drastically altering the risk-profile of their portfolios, the value proposition for hedge funds is as important as ever. Because hedge funds may be less susceptible than some fixed-income instruments to market declines should interest rates rise, they can offer investors an attractive option for portfolio diversification in a difficult investing environment.
The hedge fund industry has emerged from the financial crisis stronger than when it went in, surpassing records set in 2007 for assets under management and absolute number of funds. Over the long term, hedge funds have performed well on a relative basis and continue to offer downside protection during difficult market periods. In addition, the industry as a whole has become more institutional in nature and has adopted significant changes that help safeguard investor assets.
It is important to note, however, that not all hedge funds are created equal and they serve many different purposes. Investors need to consider their risk tolerance when selecting individual funds. When used appropriately, however, hedge funds can be an attractive addition to portfolios that seek to achieve favorable risk-adjusted returns.
Eric Siegel is global head of hedge fund research and management at Citi Private Bank.
