Put Into Perspective: Good News For Hedge Funds – ValueWalk Premium

Put Into Perspective: Good News For Hedge Funds

Hedge Funds – Put into Perspective

“An election is nothing more than the advanced auction of stolen goods.” — H. L. Mencken



Good news for hedge funds, which outpaced stocks in October

According to a Morgan Stanley Prime Brokerage Global Hedge Performance report revealed this week, hedge funds managed to outperform the stock market on average across the industry in recent weeks. This news comes as a glimmer of optimism for an otherwise pessimistic industry in which investors are pulling cash in large amounts, funds are being forced to change fee structures, minimum investments, and strategies, and some companies are even shutting down. However, while news of this performance benchmark is positive for those continu-ing to invest in or otherwise be involved with the hedge fund industry, the question remains whether it is a sign of a change of fortunes to come or merely a temporary boost.


Hedge Funds

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Some hedge fund analysts and industry leaders have predicted a turnaround of this type to come in the near future. Anthony Scaramucci, leader of SkyBridge Capital, has been outspoken on his feelings that the hedge fund industry is due for a turnaround, for instance.


Solidifying a case for liquid alternatives

Some investors consider hedge funds mysterious, aggressively managed in-vestments that may be too risky for the typical portfolio. But skeptics may be surprised to learn that the majority of hedge fund managers focus on providing capital appreciation with lower volatility than the broad markets. After all, Merriam-Webster defines “hedge” as a fence or boundary, as well as an object that is intended to restrict something such as, in this case, the risks in a portfolio. Despite the misconceptions, the popularity of hedge funds continues to grow. Hedge fund assets have climbed from $38 billion in 1990 to $2.8 trillion in 2015, representing a significant change in asset allo-cation, perhaps the most meaningful shift since many investors began mov-ing their money from bonds to stocks in the early 1980s.

Of note, it is not only institutional investors shifting assets to hedge strategies; individual investors are also moving into the space. The ad-vent of liquid alternatives fund structures, which offer hedge strategies through a mutual fund vehicle, has helped drive this shift. These structures provide wider access to hedge strategies, and can offer potential benefits in terms of liquidity, fees and transparency. Broadly speaking, traditional access to hedge funds via private placement vehicles often meant less liquidity, with redemption periods re-stricted to monthly or quarterly windows. In addition, visibility into portfolio holdings—or transparency—was limited. Liquid alternatives by contrast offer daily liquidity, security-level transparency and fees that are typically lower than those associated with traditional hedge fund vehicles.

And, unlike hedge funds, liquid alternative funds must adhere to the same regulatory requirements as US-registered mutual funds, sharing information that private placements are not required to disclose. Such liquidity, flexibility and transparency have persuaded a wider range of investors to use hedge strategies as a complement to more traditional portfolios.

Recently, interest in hedge strategies has intensified. I think this is because investors are facing a dilemma. They are searching for yield but interest rates from fixed income products have generally been low, and there is fear that equity markets could be nearing a period of intensi-fied volatility. In addition, many investors are looking for greater diversification in their portfolios (i.e., lower correlation to traditional asset classes such as stocks and government bonds). Using non-correlated strategies within a portfolio can help smooth out the ride when one particular asset class or strategy may be experiencing a volatile period. Additionally, hedge strategy managers can take short positions that benefit from market declines, cushioning a traditional long-only portfolio.

Beyond Bulls & Bear

Do hedge funds add diversification and help reduce tail risk for a pension fund's portfolio?

Can hedge funds increase the forward-looking returns of pension funds?

Pension funds must prudently invest the assets of plan beneficiaries. Most pension fund managers apply modern portfolio theory to con-struct diversified portfolios across multiple asset classes on the “Efficient Frontier” seeking to maximize risk-adjusted returns. For each com-ponent of their asset allocation, this requires a forward-looking forecast for expected return, volatility, and correlation to other components of the portfolio. These assumptions are based on a combination of long-term historical returns for an asset class, current valuation levels, and economic forecasts. Together, these variables are applied to optimization models to help determine the asset allocation with the highest expected return for a given level of volatility.

As of the end of the 3rd quarter of 2016, the Barclays Aggregate bond index was yielding approximately 2%. This would result in most pen-sions using a forward looking return assumption of approximately 2.5% for core fixed income. Many public pension funds have significant portfolio allocations to core fixed income which often comprise largely investment grade bond holdings. To enhance pension fund returns, hedge funds do not need to outperform equities. They only need to provide returns uncorrelated to equities that will outperform fixed in-come.

Do hedge funds add diversification and help reduce tail risk for a pension fund's portfolio?

One practical shortcoming of applying modern portfolio theory when diversifying allocations across multiple asset classes, is that these mod-els have proven to break down during severe market sell-offs. This was a painful lesson learned by pension funds in 2008 when almost all segments of their portfolio declined simultaneously. The reason these models break down is because two of the inputs are dynamic. When markets sell off, correlations among both long only investment managers and asset classes tend to rise significantly. When combined with a spike in volatility, this creates much more tail risk than originally perceived. In contrast, many hedge fund strategies have correlations that are very low relative to the capital markets benchmarks and some have the potential to become negatively correlated during a market sell-off. This was seen in 2008 when a few hedge fund strategies posted positive returns.

Many pension funds were fortunate that a relatively quick recovery of the capital markets was precipitated by quantitative easing. However, equities can sustain significant declines for long periods of time. For example, the US stock market declined over 80% during the great de-pression and took 23 years to recover. The Japanese Nikkei index hit an all-time high of approximately 39,000 in 1989, and more than 25 years later is still below half its peak. Since most public pension funds are heavily under-funded, a prolonged sell-off in the capital markets would leave many pension plans unable to pay benefits without increased funding at a time when state and local governments can least afford to make additional contributions to these plans.

Three keys to investing in hedge funds to help improve the probability of success.

  • Understand that hedge funds are not an asset class but a fund structure consisting of numerous investment strategies. The performance of hedge fund strategies and their correlations relative to long only benchmarks varies greatly. In a diversified hedge fund portfolio, choosing the right strategy is more important than manager selection. Successful investing in hedge funds requires choosing strategies that will enhance a portfolio in the context of an investor's objectives. Some examples include:
    • Reduce the volatility and tail risk in the portfolio.
    • Outperform the risk-free rate by 4% annually.
    • Build a portfolio of fixed income oriented strategies that will enhance the risk adjusted return of the fixed income portion of the portfolio.
    • Outperform the equity markets with less risk.

Each of these objectives requires a very different composition of hedge fund strategies and benchmarks.

  • Selecting managers who are likely to outperform is critical. With low barriers to entry and over 15,000 hedge funds in the industry, we believe only 10% of managers deliver on their value proposition and justify their fees. This is why hedge fund indices, which track perfor-mance across the industry, perform poorly. The biggest mistake many investors make is only investing in the largest managers with the strongest brands. Unfortunately, many of these managers have allowed their assets to swell well above their optimal capacity which causes returns to be diluted. Often the best performing managers are small and midsized managers with nimble investment portfolios.
  • Hedge fund managers should be evaluated across multiple factors including: organization, investment team, investment philosophy and process, performance, risk controls, and service providers. The managers who have the highest probability of outperforming are those who rank well across each of these factors, have identified (and can clearly articulate) an inefficiency in the market, and have a differen-tial advantage in capturing that inefficiency.
  • Fees matter. Despite many articles to the contrary, the traditional hedge fund fee structure of a 1.5% to 2.0% management fee and a 20% performance fee, is not dead. This is what most investors continue to pay unless they are investing in emerging managers that are offering founder's share discounts or 40 ACT funds. However, many hedge funds have begun to scale or negotiate their fees schedule, providing meaningful discounts for larger allocations. Large pension funds should not be paying traditional hedge fund fees to most managers.

Agecroft Partners

Article by Skenderbeg Alternative Investments

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