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What do I need to know about hedge funds and “drawdown protection”?

Over the years, we have been presented many reasons for investing in hedge funds. Since 2008, the most common rationale has been “drawdown protection.”

While seemingly an admirable goal, drawdown protection is poorly defined and many investors don’t realize that their expectations won’t be met during all periods of market volatility. Investors should consider drawdown protection in the context of three categories: short-term drawdown protection with liquidity; a lack of exposure to equity markets, which dampens portfolio volatility over longer time periods; and access to opportunistic strategies, which may shorten the time period to recovery. The second category can be more precisely defined as the reduction of downside market exposure at the same expected return when hedge funds are combined with traditional assets. This occurs when a hedge fund’s net-offer expected return exceeds its beta adjusted stock market return.

The decrease in downside risk without sacrificing realizable return cannot be the result simply of a beta substantially below one, and may not be present in all volatile markets. For instance, many liquid systematic funds (trend-following and other related strategies) provide the first and second kinds of downside protection. During the financial crisis, they were highly liquid, had limited equity exposure and performed well. However, from 2011 through early 2014, they contributed significant negative returns to portfolios before rebounding in late 2014 through early 2015.

Systematic funds provide diversification benefits to traditional portfolios because they have average realizable returns above the beta-adjusted market return and are expected to positively contribute to portfolio performance over time. Since there is no “free lunch,” the higher volatility profile of systematic strategies may be the cause of portfolio drawdowns, as well as protection against them, depending on the market environment.

We believe the positives for these strategies outweigh the negatives.

Many investors fail to include liquidity concerns when attempting to protect their portfolios from downside risks. While many hedge funds control losses during equity market drawdowns, withdrawals may be unexpectedly limited during these times. This results in investors raising capital from relatively cheap assets (discounted equities) while maintaining positions in hedge funds that did not significantly decline to meet any cash needs.

Access to cash should be factored into the objective of downside protection, and the liquidity of the “hedge” must match the need for cash. There is evidence that investors can obtain greater protection from long-term drawdowns if they have enough staying power to sacrifice daily and weekly liquidity for monthly liquidity.1

Finally, certain hedge fund strategies may be flexible enough to take advantage of dislocations in asset classes that are unavailable through traditional investment vehicles. For instance, many hedge funds were able to profit from the collapse in the mortgage-backed securities markets in 2007–2008 or to invest in distressed debt and post-reorganization equities in 2009.

This ability to quickly invest in unique opportunities is one of the key benefits we value in our hedge fund allocation. Performance can vary greatly from traditional equities, but this does not mean that these funds will provide downside protection during equity sell-offs.

Investing in some hedge fund styles can provide significant enhancements to diversified portfolios, especially during times of equity market distress. Since strategies vary considerably in the hedge fund universe, investors must clearly define their objectives and constraints when considering an allocation to hedge funds. Drawdown protection is a vague goal that does not account for important features of hedge fund investing and must be linked to specific aims.

1See “Liquidity: At What Cost?” Prequin Hedge Fund Spotlight, December 2012.

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 December/January 2016 issue of Worth.

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