• In the years ahead, markets will enter into a new era of change characterised
      by higher market volatility and uncertainty.
    • For some time now, we have been advocating for investors with moderate
      and aggressive risk profiles to have a 14% allocation to hedge
      funds/alternatives in their asset allocation.
    • By allocating across hedge fund strategies, investors can access diversified
      approaches that seek to provide consistent, risk-adjusted returns with
      reduced volatility.

Shifting tides—A more uncertain world

Ten years after the financial crisis, financial markets are entering into a new era of change that will make the next decade look very different. Investors who assume that the future will resemble the past will be in for a rude awakening. The last
decade has been characterized by easy central bank policies; subdued inflation; free trade and capital flows; and low market volatility. As we look ahead, we expect a very different macro landscape to transpire, for better or worse.

Underlying shifts are already happening: Central banks are retreating from their easy monetary policies; the regulatory debate is shifting from the financial to the tech sector; and protectionism is on the rise. As the outlook becomes murkier, the key for investors is to diversify. One of the best ways to diversify is through hedge funds and alternatives.

A little bit of diversification goes a long way

Post crisis, it has become a standard refrain that correlations between asset classes have risen, making it more difficult for investors to find true diversifiers in their portfolios. A broader perspective will help: alternative strategies including hedge funds not only allow better protection against short-term market swings, it also allows portfolios to be designed with lower long-term volatility in mind. That is a design feature that investors should cherish: the ability to maintain roughly the same return expectations in portfolios, but dampening volatility.

The attraction of alternatives, especially hedge funds lies in their ability to exploit additional sources of returns, e.g. illiquidity premia or short-selling, while exhibiting low to no correlation to traditional asset classes. Thus, they enable investors to broaden the available opportunity set and promote portfolio diversification.

Hedge funds thrive in rising rates

Ever since the financial crisis, hedge funds struggled under a zero risk-free rate world. This is because zero risk-free rates complicate capital allocation decisions. In fact, hedge fund performed well before the financial crisis and did better than equity markets during rising rate environments, during the 1994 and 2004 rate hike cycles

In particular, managed futures strategies (CTA) typically carry substantial cash balances, particularly futures-only vehicles where more than 90% of net assets may be in cash. All else equal, any rise in rates should therefore feed directly into bottom line performance. As risk-free rate are poised to rise, hedge funds should capitalize from this trend.

Flourishing in late cycle equity bull run

The equity bull market is nearing ten years old. Looking ahead, the market will face the prospect of larger moves in inflation and policy, as well as the risks of inflection points in earnings and economic growth – all of which will form a potent mix for
market volatility.

History shows the tricky hand-off from monetary accommodation to normalization is often accompanied by policy overshooting and heightened volatility. It is more likely that we will see a late-cycle market characterized by heightened volatility and a broadly challenging environment for returns, but a limited scope for a very deep crash.

Examples of hedge fund strategies include equity market neutral and global macro strategies that look for opportunities across multiple asset classes.

Traditional long-only equity investments typically require timing and patience. Macro risk events in the past few years – from China’s currency devaluation, Brexit to President’s Trump’s victory – have shocked investors, causing a wave of investments into passive equity strategies, with no drawdown protection. For investors looking for some protection from potential equity market drawdowns, hedge funds seek to provide consistent performance with reduced volatility and low
correlation to equity markets. Historical monthly return comparison shows that hedge funds exhibit lower and less frequent drawdowns relative to global equity markets (Chart 2).

Hedge funds improves portfolio’s risk-adjusted returns

Hedge fund managers’ investment mandates are flexible enough to invest capital freely compared to the constraints faced by benchmark-oriented managers. For example, hedge fund managers have the ability to sell securities short, should they
identify issue they find are overvalued. The long-only fund managers are handicapped without the ability to short, and hence the expression of any negative view is limited to not owning the position. In addition to being a potential source of return generation, selling securities short can prove to be a hedging and risk management tool, particularly useful in times of market distress.

Due in part to the distinctive drivers of return that hedge funds access and to the role played by alpha, hedge fund returns have been less correlated to many other asset classes in investor portfolios, particularly traditional asset classes. This means hedge funds can potentially generate significant diversification benefits in multi-asset class portfolios (Chart 3).

Not all hedge funds created equal

The hedge fund industry is highly diverse, comprising different managers pursuing a wide range of investment strategies. Hedge fund performance at the industry level fails to take into account the differences at the individual manager level, which can be very wide. 

According to a hedge fund research database, the difference between first and fourth quartile performers, for example, can be as large as 20%. Furthermore, that spread has tended to be higher in times of market stress. 

Selecting the right hedge fund manager is key

As dispersion in the performance between hedge funds can be very wide, selecting the right hedge fund managers is paramount. In order to do so, manager selection should be based on a well- designed due diligence process. Hedge funds should be evaluated on their track record: their ability over time to produce strong risk-adjusted returns, while mitigating both portfolio volatility and drawdowns through a range of market stress scenarios and downturns. Once a credible manager is selected, there is a need for constant monitoring and re- evaluation of managers to ensure that the original investment objectives remain intact and that the managers are positioned to perform in the environment at each point in time. 

Diversifying through a portfolio of hedge funds

A portfolio of hedge funds can offer investors the opportunity to hold a more diversified hedge fund exposure in their portfolio, thereby hedging against idiosyncratic manager and market risks, as well as allowing them to take advantage of more diverse opportunity sets than provided by allocations to a single-manager hedge fund. 

Adapt your asset allocation 

For some years now, we have been advocating for investors with moderate and aggressive risk profiles to have a 10% allocation to hedge funds/alternatives in their strategic asset allocation. Last year in August, we raised our tactical asset allocation to hedge funds/alternatives to 14%. We continue to hold that view. We are optimistic that the best of breed hedge funds are well-suited to thrive in this new world of greater uncertainty. 

Contact us today for further insight.