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We believe some of these are now unwinding and highlight several changing market dynamics which could be highly supportive of the sector looking forward. We remain positive on the role that alternatives can play within an institutional portfolio and argue that the performance set for alternatives will be richer in the next ten years compared to the past ten.
As the interest in alternatives continues to rise, this paper provides an overview of the different types of hedge fund strategies including alternative risk premia and touches on several cyclical and structural forces which have acted as headwinds for many strategies since the GFC. We believe some of these headwinds are now unwinding and highlight several changing market dynamics which could be highly supportive of the sector looking forward, and hence be able to provide important diversification benefits for investors.
The purpose of this section is to tackle some topical issues surrounding what has become known as investing in alternative investment strategies with a specific focus on hedge funds and the sub sector of alternative risk premia. Since the financial crisis of 2008, contrary to popular belief in some circles, institutional investing in alternative strategies has increased dramatically, as global investors seek to increase diversification of their portfolios and, perhaps more importantly, seek returns that are not dependant on rising equity markets. While the classical hedge fund strategies are still prominent, alternatives investing now encapsulates an incredibly large scope of underlying strategies, investment vehicles and choices. In the context of a global equity bull market that is now it is tenth year since the crisis, low global government bond yields, and tight credit spreads, the interest in alternatives has never been higher across the Australian market.
In this section we attempt to cover the below issues:
Set clear definitions of Absolute Returns strategies, including those covering:
Defining Hedge Fund strategies
Firstly, JANA does not view absolute return funds or hedge funds as an asset class. We view the classification as a wide spectrum of investment strategies that use traditional asset classes and their derivatives to create distinct return streams separate from traditional market drivers. This wide-ranging group of strategies attempt to use sophisticated risk management and trading techniques to generate superior risk adjusted returns than those achievable by traditional long-only active and passive investing.
The broad classifications of hedge fund strategies have remained quite consistent since the initial development of the industry in the 1980s and 90s. Although there is a significant degree of crossover between specific strategies (as with all asset classes), from the perspective of JANA and its clients we feel the most relevant group of strategies include:
A strategy that seek to profit from movements in fixed income, equity, commodities, and foreign exchange. Positioning is often backed by detailed fundamental research that covers macroeconomics, politics, market research and based on economic fundamentals. Portfolio construction can either be driven by systematic rules (quantitative) or by discretionary portfolio managers, as well as being highly diversified, or concentrated in specific themes. Wide performance dispersion is often seen across the global macro peer group as it is one of the most flexible investment strategies, having varied underlying market exposures at any given time and fund biases. Given the wide range of styles, the resulting performance can either be very volatile or very controlled (i.e. low volatility). Trend following typically falls under the umbrella of global macro.
A fund can often be active in multiple strategies to increase strategy diversification and seek scale. These are typically very large funds with a long-term track record, and have expanded into other strategies over time, typically by hiring new specialist portfolio managers. There are significant advantages in terms of technological scale, diversification, and the ability to dynamically allocate to strategies based on opportunity set. However, they tend to be expensive and hard to access.
Fixed Income Relative Value
A market neutral strategy that trades discrepancies between two high related fixed income securities. Often called arbitrage, the strategy can trade between government bonds and their derivatives (i.e. futures), as well as two bonds of similar maturity who exhibit small pricing differentials. It is a highly technical strategy which can produce steady returns over time, however does require significant amounts of leverage and inherent basis risk.
Equity Long Short
A relatively straight forward hedge fund strategy where funds take long positions in favoured stocks and short positions in unfavoured stocks. By assets under management, it is the largest hedge fund strategy. Funds can take on a wide array of characteristics, either small or short, sector focussed or generalist, single portfolio manager or multi portfolio manager. While most equity long short funds are long biased, many funds are also market neutral and rely on pure alpha to generate returns (albeit do so with leverage). The key characteristic is that while long only equity funds often still maintain long positions in stocks they do not like (i.e. to manager benchmark risk), in equity hedge funds, the fund will not hold such a stock and may even short it. In the absence of short stock ideas, the manager may short the market (i.e. via futures) to reduce beta.
Typically an equity-based strategy that trades in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, or debt restructures. While some strategies may be market neutral (i.e. merger arbitrage), this type of strategy tends to be long biased although it is a highly varied hedge fund classification. Activist event driven funds can take large positions in underlying companies and seek to influence the future direction of the company. Distressed debt investing and deep value credit can also fall under this strategy umbrella.
While the above list is not exhaustive, most hedge funds can be classified into the above strategy groups. More niche underlying strategies can focus on an almost infinite amount of specific approaches, including sector specialist (i.e. long/short technology), relative value trading within asset markets (i.e. volatility or credit relative value).
The matrix below from Hedge Fund Research shows headline strategy classifications as well as the large number of underlying strategies:
Over the past five years, liquid alternatives have become increasingly popular with investors, which in turn gave rise to Risk Premia investing. Risk premia strategies attempt to replicate well-documented strategies that persist thought time and have been indirectly a source of profit for hedge funds within the above strategy classifications. We view alternative risk premia as a sub sector of hedge funds, with their own benefits and issues to consider. Also like most hedge fund strategies, risk premia strategies tend to be cyclical and have their own driving forces affecting performance and volatility. In addition, they should be seen in the context of long term low correlation with other asset classes and part of a well evolved alternatives program.
We feel there are many positive attributes to Risk Premia investing, although they must be seen in a total portfolio context with the risk of the underlying strategies, or premia, well understood. Today, there are over 30 institutional alternative risk premia providers which offer commingled funds offering access to many underlying strategies in cost effective and liquid structure. Moreover, specific premia, for example equity value or commodity carry, can also be accessed via specific ETFs or strategy swaps offered by banks.
The chart below (from BlackRock) illustrates the large amount of underlying premia that a single fund multi-alternative risk premia fund seeks to harvest, as well as the breakdown by asset class.
Absolute Return Bond Funds
Absolute return bond funds (ARBF) have increased in popularity in recent years for investors who wish to generate alternative return streams while still retaining exposure to the asset class. Performance is often generated from a wide array of relative value strategies, such as long short corporate credit, macro rates trading, and structured credit. There is a relatively small number of active ARBF funds, as they are typically seen as a hybrid between a hedge fund and traditional fixed interest fund. Recently, there has been a trend for long-only asset managers offering more absolute return style funds, and likewise for hedge funds offering ‘light’ versions of their hedge funds (lower fees, less complexity, higher transparency). This has largely been demand-driven by global investors wishing to eke out higher returns in their defensive allocations and the ongoing “search for yield”.
Absolute Return strategy performance
While having an “absolute’ return focus, many hedge fund and risk premia strategies are highly cyclical and, like any other investment strategy, can have rich and poor opportunity sets at any given time. Like any other asset classes, they have their own driving forces that can influence performance and volatility. However, there has been a longer term trend that has seen overall hedge fund performance come down in aggregate, and is far off the double-digit returns achieved in the 80s and 90s, and even before the financial crisis. We would broadly agree with this view and present a number of observations below to help explain this.
A note on hedge fund indices:Before discussing hedge fund performance, we would like to highlight the inherent weakness of hedge fund indices, although we do use them here as a proxy for industry and strategy performance. Given the huge sub set of investment styles within each classification, hedge fund index performance has a tendency to converge to zero with very large quartile bands. When investing in these strategies, manager selection is critical, as there will always be poor quality funds that drag down an index, while conversely there will usually be a handful of quality managers that perform consistently well in the peer group. While there are benefits in using hedge fund indices, a level of understanding regarding their composition and other issues such as survivorship bias is necessarily to apply the appropriate level of merit to any insight arising from their use.
We present several discussion points below which assesses the history of hedge fund strategy performance with a focus on the past ten years, discussing the head and tailwinds for some of the major strategy in the past and in the current environment. The below table is interesting as it graphically shows relative performance of each major hedge fund strategy through the years, showing that strategies can be cyclical and have good and bad years with often large dispersion between them (bottom row).
As can been see in the following chart, there has been a secular decline across the four major hedge fund strategy groups since 1990 (initiation of HFRI index data).
The above chart highlights the high returns achieved in the 90s, when there were far fewer hedge funds and risk levels were much higher; back then the composition of investors were typically wealthy individuals who could afford to take on these levels of risk and were more focussed on overall returns. The first inflection point of performance was seen in the late 1990s to 2001, which included the collapse of the hedge fund LTCM, the Russia crisis, and then the implosion of the tech bubble. While hedge funds fared much better than traditional equity markets, these events would take a toll on the levels of risk and eventual performance up until 2008, although as can be seen, hedge funds generally did quite well over this period across most strategies. 2008 was another watershed moment, with hedge funds arguably ‘failing’ their investors who improperly believed they should be completely immune to market stress.
Most equity and credit-related strategies suffered losses in 2008, however they did manage to recover in the following years as risk assets recovered and liquidity returned to the financial system. Global Macro and Trend following (CTAs) were the standout performers during the crisis, with many funds returning +20% in 2008. However, unlike long-biased strategies, Global Macro performance has struggled in the years following the crisis. We discuss the reasons behind this in the next section, however they can be summarised as: ultra-low volatility in asset markets, zero interest rate policies (most macro funds are rates & FX-focussed), and low dispersion amongst regions and assets due to coordinated global stimulus packages. We feel that these factors are currently dissipating and even reversing.
Performance for the various strategies is shown below versus global equities, bonds and cash objectives. While we have discussed and shown that hedge fund performance has declined over time, performance over the various time frames still compares moderately well against the cash + 3% benchmark that we use internally for more conservative alternatives funds. As expected, hedge fund performance lags equities during strong bull markets, and is expected to generate returns in between that of equities and bonds over the long term, with low correlation to both.
The low correlation of specific strategies (not all) and ability to generate long-term performance supports the argument of including hedge funds in portfolios as a diversification tool, despite the recent lacklustre returns. As can be seen below, Global Macro is the strategy most likely to yield diversification benefits to a portfolio of otherwise long-biased funds.
We view the performance of hedge funds over the past ten years in the context of a number of both structural and cyclical forces, which have hampered both the opportunity set for the industry and resulted in below-expectations results. These are summarised below:
Over time, overall risk levels have reduced in aggregate in hedge funds. This is a long-term trend, and we would not expect for most hedge funds to return to the days of the 1980s where funds could have up or down 20% months and have volatility in excess of 40% per annum. Like many other global industries (i.e. banking), excesses have come down and overall activity has been moderated. While we expect risk taking to increase compared the last few years, we would expect this to normalise around more ‘healthy’ levels seen in the 2002-2007 period rather than that of prior decades.
Technological developments have meant that previously hard-to-access information is now readily available to a much larger set of would-be investors. A key example of this is monetary policy insights previously gained from close contacts at central banks and having access to central bank meeting minutes and speeches. Now a whole array of information is available via the internet and anyone with an internet connection can actually watch Fed speeches live. Analogies can be drawn with access to equity financial statements, crop yield analysis, and country macroeconomic data.
High fees, glamour, and entrepreneurial drive has led to a huge rise in the number of active hedge funds. While there was only a handful in the 1980s and a couple of hundred in the early 1990s, today there are estimated to be over 8,000 active funds, with hundreds both opening and closing each year. This has meant that the overall quality of funds has reduced, and hence hedge fund index returns have also been skewed downwards.
The inflows from institutional investors has had a dramatic effect on both risk-taking behaviour, as well as high performing funds accepting too much capital and diluting returns. Hedge funds tend to be more aggressive in their early years, and once they attract institutional capital they have an increased bias to be more conservative in order to protect their business. It is important to note that this is not true for all successful funds but is a common characteristic in aggregate.
In the wake of 2008, investors demanded hedge funds implement elaborate and strict risk management policies. With the rise of institutional investors and their consultants, a huge emphasis was placed on risk management frameworks, with some funds finding themselves as ‘failing’ due diligence if they did not have a separate risk team with oversight, strict stop-loss rules, etc. The overall effect this has had on the industry it to supress risk taking. As time since the crisis continues to grow, it is likely that firms may become more liberal in how they execute their strategies and be driven by risk and reward probabilities, rather than be overly focussed on the downside.
Ultra-low interest rates have affected several hedge fund strategies for a number of years and is seen by many as the number one headwind for hedge fund performance over the past eight years. Many of the leading global macro funds that performed well during the 2008 crisis were rates specialists, so with such low rates their opportunity set has been depleted for many years now. With rates now rising in the US, and the EU likely to follow at some time, we feel this incredibly suppressive factor of low interest rates has come to an end.
Quantitative easing policies is highly related to the above factor of low interest rates. Both flooded the global monetary system with capital and encouraged wide-spread risk taking and ultra-low asset volatility. Given most hedge funds strategies require healthy levels of volatility and performance dispersion, QE has been seen as a major suppressant of performance. Like ultra-low interest rates, we feel that the effects of QE on global markets is now reversing.
Despite the above factors that we feel have negatively affected hedge fund performance, we note the below points which keeps us positive on the outlook for alternatives and the importance of strategy and manager selection:
Reasons for optimism:
Investing in hedge funds continues to be a core focus for leading institutional investors such as sovereign wealth funds, endowments, charities, private wealth, and insurance companies seeking to diversify away from traditional markets. While performance has been lacklustre in aggregate across the industry, we feel this has been driven by several structural and cyclical factors. We believe a number of these cyclical headwinds are now reversing which may lead to a return to healthy levels of volatility, less central bank interference, and increased asset class and regional dispersion: all very positive developments for hedge fund strategies. Overall, while the past few years have seen muted returns especially at the hedge fund index level, this has been during a time where investors have seen strong returns from rising equity markets and capital gains in their bond portfolios. Should these traditional sources of returns moderate, we feel that alternatives could play an important and positive part in institutional portfolios over the next ten years.
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