SHARE

Partner Content

Is there a selective argument for hedge funds?

Hedge fund performance has suffered in recent years, so much so that some investors are losing interest in the sector. Certainly, it’s true that in most categories the estimated structural alphas of the overall hedge fund composites have diminished substantially; they even turned negative from 2004 through 2015. But is the harsh overall outlook on hedge funds justified?

Based on Drexel Morgan Capital Advisers research, a number of factors explain their poor performance from March 2004 to May 2015: Specifically, the period of “great moderation” until June 2007 lacked the sustained high-market volatility and dispersion that equity-oriented styles require to be successful.

Moreover, from 2009 through 2015, markets were heavily influenced by central banks, as evidenced by abnormally low interest rates, asset-price volatility and return dispersion across individual securities. Allianz’s Mohamed A. El-Erian, for example, notes that unprecedented monetary expansion led to security “prices and correlations no longer following established analytical and historical patterns.”1

Other negative influences included more capital chasing a limited opportunity set.

As a result, clients and industry colleagues have voiced concerns that many hedge funds will not provide the same degree of downside protection and improve risk/return trade-offs as well as a 60/40 balanced portfolio of equities and bonds would.

This concern is understandable, but it might be an overreaction. Hedge funds that fall into the “relative value” and “systematic” categories have not experienced significant declines in structural alphas from 2004 through May 2015.2

For 25 years, and all sub-periods reviewed, allocations to the systematic and relative value strategies within the hedge fund universe consistently improved the risk/return profile of portfolios.

Systematic and relative value hedge funds outperformed a 60/40 mix during periods of substantial monthly equity market declines, from May 2010 through March 2015. Meanwhile, the other hedge fund styles, such as those that are “event driven” as specified by the HFRI Event Driven Index and the “equity hedge” variety included in the HFRI Equity Hedge Index, did not.

In fact, over the full 25-year period (January 1991 through March 2015) of our research, all hedge fund index categories provided, on balance, substantial downside protection, while fewer categories provided such protection in the shorter time periods beginning at later dates.

For the entire 25-year period, and all subperiods reviewed, allocations to the systematic and relative value strategies within the hedge fund universe consistently improved the risk/return profile of portfolios, compared to those with a standard 60 percent equity/40 percent bond allocation.

Thus, the number of hedge fund strategies complementing traditional asset portfolios has fallen, but two significant ones remain. The stability of past results suggests that the remainders are more likely to provide some of the diversification benefits that investors desire.

1Mohamed A. El-Erian, The Only Game in Town: Central Banks’ Instability and Avoiding the Next Collapse. New York: Random House, 2016, Chapter 17.

2The organization HFR (Hedge Fund Research) publishes analytical work about the hedge fund industry, and we’re using HFR’s classification here.

This essay is adapted from “The Changing Benefits of Adding Hedge Funds to Traditional Asset Allocations,” by James L. McCabe and Joseph Zaccardi, October 2015. Data provided by Drexel Morgan Capital Advisers, and Zephyr.All information contained herein is based on past performance and is not intended to be indicative of future results. There is no guarantee that historical risk and rate of return will persist in the future. The views and opinions expressed above are those of the portfolio management team at the time of writing and are subject to market, economic and other conditions that may change at any time; and, therefore, actual results may differ materially from those expected. This material does not constitute a recommendation to the suitability of any product or security and does not constitute an offer to buy or sell any financial instrument or to participate in any trading strategy. The analysis provided should not be relied upon as the sole factor in an investment decision. All investments contain associated inherent risks, including possible loss of principal.

This article was originally published in the April/May 2016 issue of Worth.

Topics

Disclaimer: Worth magazine is a financial publisher and does not recommend or endorse investment, legal, insurance or tax advisors. The listing of any firm in the 2019 Worth® Leading AdvisorsTM Program does not constitute a recommendation or endorsement by Worth magazine of any such firm and is not based upon Worth magazine’s experience with, or prior dealings with, any advisor. The information presented for each advisor, including but not limited to any related profile, statistical data, presentation, report, commentary, recommendation or strategy, has been provided by such advisor without review or independent verification by Worth magazine. Any such information is the sole responsibility of the advisor. Worth magazine makes no representation or warranty as to the accuracy or completeness of such information, assumes no liability for any inaccuracies or omissions therein and disclaims responsibility for the suitability of any particular investment recommendation or strategy for any person. Nothing contained in Worth magazine constitutes or should be construed as any form of investment, legal, insurance or tax advice or as a recommendation to buy, sell, hold or trade any securities, financial instruments or assets. Readers are advised to consult their legal, financial, insurance and tax advisors prior to making any investment or pursuing any investment strategy. Past, model or hypothetical performance is not indicative of future results.

back to top