- 2021 appears to have been the turning point for a 30-year period of disinflationary global trends which led to elevated asset prices and suppressed volatility. Going forward, financial assets will need to reprice, but at levels that are unpredictable. What investors can be certain of is that the path to terminal value will be more volatile than during the past 10 years.
- In this new market regime, the previously successful portfolio asset mix (60/40 equities/ bonds) is unlikely to perform as well. As a result, investors should look to find alternatives to add to their current portfolio allocation.
- One area to re-examine is liquid alternatives, such as hedge funds, but how they are included will be crucial in order to generate attractive portfolio performances.
Evolution of the industry
“Alternative investments”, i.e. hedge funds, is a very broad term and to grasp what this industry is about, it is worth taking a step back to look at its origins, its evolution, the various strategies that have emerged and how they have fared in different market environments.
The origins of the industry are generally believed to date back to the late 1940s, with the first partnership that invested in a portfolio of both long stocks and a basket of short stocks to cover certain market and factor risks of the long portfolio. In short, hedge funds have been in existence for many decades.
The 1970s and 1980s saw the emergence of some legendary firms in strategies such as global macro and long/short equity, some of which still exist today. It also saw the birth of funds of hedge funds – the possibility to invest in a group of hedge funds though one single vehicle. The 1990s saw a real boom in the industry with the emergence of multiple new strategies, such as arbitrage and relative value, and an explosion in the number of funds. It also saw the creation of hedge fund benchmarks, such as Hedge Fund Research (HFR) and Credit Suisse/ Tremont indices.
Growth continued in the early 2000s. As global stock markets fell by around 45% between 2000 and 2002, hedge fund strategies managed, on average, to post positive returns. This feature caught the eye of institutional investors, which started to make significant investments in hedge funds between 2003 and 2008. This development allowed the industry, which until then had been mostly invested in by private high net worth clients, to become more mainstream and to be included in the asset allocations of a broader group of investors.
After this classic sequence of development and growth came a phase of maturation, starting in 2009.
Many aspects of the industry that may have been true in its early days and remain as a perception for some market participants, have changed today. The emergence of regulated structures, such as alternative UCITS, have democratised access to hedge funds, with lower minimum investments, better liquidity, greater transparency, and cheaper fees. Even unregulated funds have had to adapt, providing generally much better transparency than in the past.
Performance in different environments
Alternative strategies have, on aggregate, limited sensitivity to traditional markets, such as equities and bonds. The best environments for these strategies are markets which are driven by fundamentals, where there is real price discrimination between securities, companies and sectors, as well as reasonable volatility. Some strategies also tend to benefit from large dislocations.
In contrast, markets with compressed volatility, large central bank and government interventions, and persistently low interest rates, as has been seen in several years since 2008, do not provide an attractive opportunity set for alternative strategies.
As mentioned above, the burst of the dotcom bubble, followed by the recession of 2001–2002, allowed these strategies to benefit from the gradual repricing of markets and generate positive returns, while equity markets lost 45% of their value. Even in 2007 & 2008, alternatives were performing quite well until the collapse of Lehman Brothers, which brought chaos to markets, which ground to a halt for several months.
The analysis of past returns can be split into three periods:
1) 1990-2009 - The golden years: During this period, alternatives materially outperformed equity and fixed-income markets, with reasonable volatility and drawdowns. The risk/ reward and diversification benefits were very attractive.
2) 2010-2019 - The underperformance years: This timespan coincided with a period of continuous central bank intervention, which suppressed market volatility and dispersion. As a result, alternative strategies underperformed equities and performed in line with government bonds. They provided some diversification benefits, but the risk/ reward was relatively unattractive.
3) 2020 and beyond - Time to reconsider: With the changes we have seen in macroeconomic and financial conditions over the last two or so years, markets have been more favourable for alternatives. They are once again showing attractive risk/reward profiles and strong diversification benefits compared with traditional assets.
Will performances revert back to their historical averages?
Another way of looking at this is to compare the performance of hedge funds with a 60/40 equities/bond portfolio since the GFC* and over the long term. As the chart on the right shows, conditions since the GFC have been particularly favourable for traditional asset classes compared with their long-term averages, despite the drawdown we have seen so far in 2022. In contrast, as mentioned above, hedge funds have underperformed their historical averages. If these trends were to revert, the attractiveness of hedge funds compared with traditional asset classes would increase significantly.
The opportunity set in today’s markets
We have entered a new market regime, characterised by higher rates & inflation, the end of quantitative easing and elevated market volatility. In this context, several alternative strategies are seeing an improved opportunity set that should help them deliver attractive returns. The many challenges facing investors today, such as geopolitical instability, the general trend away from globalisation and higher levels of inflation, could last for some time. These uncertainties could have a pronounced short-term impact on asset prices and should be considered by investors in their asset allocation decisions.
In terms of the opportunity set for alternative strategies, the selection of strategies and managers remain key. Each broad strategy can be broken down by investment style.
In long/short equity, less directional/ low net exposure managers should be favoured, but at some point, investors should rotate into more directional sector specialists. As fundamentals generally drive share prices in the long term, these managers should be well positioned to generate attractive returns.
For diversifying strategies, macro and commodities should continue to present an above-average opportunity set. These strategies are supported by a number of tailwinds, including higher front-end rates, central bank policies determined by economic fundamentals, commodity pricing set by supply-side constraints, higher levels of volatility, and equity market noise.
In fixed income, the sell-off across credit markets is beginning to produce some attractive long opportunities. The environment is also improving for corporate credit managers, which are able to generate alpha on both the long and short sides of portfolios. Default rates may not necessarily increase substantially from here, but dispersion, spread widening and volatility all provide a fertile opportunity set. This increased volatility and dispersion should also favour relative-value strategies.
One investment approach that has attracted the most talent and growth of the industry over the past years is multi-strategy funds. Multi-strategy funds are those that allocate to more than one alternative strategy or portfolio manager (PM) to a single vehicle. They have benefited from structural trends to attract talented PM teams: the closure of investment banks’ proprietary trading desks, more regulation, and higher operational and financial burdens have led PMs to opt for this solution instead of setting up their own structures. These funds have generated attractive and robust performances as a group, even through the recent market volatility, outperforming the overall hedge fund industry. The ability of these funds to source talent, provide welldiversified exposure and strong risk management, has been the main factor for their success. In contrast, these structures tend to have higher total expense ratios (TER) and generally less attractive dealing terms. However, we believe these negatives are more than compensated for by the attractiveness of the approach, and that current markets should allow multi-strategy funds to continue to perform well.
Alternative strategies have been in existence for several decades and the industry, which has gone through various cycles, has evolved and matured. The emergence of regulated funds, greater transparency, improved liquidity and more attractive fees are the consequences of this evolution. Today, a broad range of investment strategies and formats that can play different roles in a client portfolio are available to investors.
We believe that the global economy and financial markets are moving into a challenging environment that will be more sustained. As a result, investors must prepare themselves for returns from traditional assets, such as equities and bonds, to revert to their long-term, riskadjusted historical ranges. To offset this compression of returns and increase in volatility, alternatives should form a significant proportion of any portfolio’s asset mix.