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Regulated alternative investments -- aka mutual funds -- may cannibalize hedge funds
April 15, 2011 — 2:56 PM UTC by Scott Welch, Guest columnist
This column by Scott Welch of Fortigent, LLC was originally published in Investment Management Consultants Association’s March/April 2011 issue of Investments & Wealth Monitor. Visit IMCA’s Web site: www.IMCA.org to access more articles.
Opinions and use of alternative investments have fluctuated wildly since they became popular with high-net-worth investors in the early 1990s. In the early years (1995–2006), investors accessed alternatives primarily through “absolute return,”(1) hedged equity, and commodity trading advisor (CTA or managed futures) strategies. Most high-net-worth investors sought exposure via multi-manager funds of funds (FoFs), which provided access, lower investment minimums, diversification, asset allocation, and risk management in exchange for an additional layer of fees.
In my practice, I’ve seen many investors deploy alternative investments at the implementation rather than the allocation stage of portfolio construction, carving out some portion of their fixed income allocation for absolute return strategies and some smaller portion of their equity allocation for hedged equity and CTA strategies. During the tech bubble and the bear market that followed during 2000–2003, these strategies performed well and helped offset the dramatic drawdowns suffered by most equity portfolios. Life was good.
Success begets imitation, and during 2003–2008 demand for alternative investments increased dramatically,(2) new funds proliferated, and strategies became increasingly specialized and granular. Many investors grew more confident in alternative investments and, rather than viewing them as surrogates for equity or fixed income, began to include alternative investment “asset classes” at the allocation stage of portfolio construction. Other investors began to disintermediate away from FoFs and invest directly into single-manager, single-strategy funds.
The primary access vehicle for these strategies, whether single strategy or FoF, remained limited partnerships (LPs), also broadly referred to as “hedge funds.”(3)
The objective of alternative investing for many investors during this period shifted away from portfolio diversification toward portfolio alpha generation. Interest rates were low, volatility was low, credit was easily accessible, and both equity and fixed income markets enjoyed relative bull markets. In this “green grass and high tides” environment, many investors seemed to forget or ignore liquidity risk, increasingly excessive leverage, counterparty risk, fraud risk, and many of the other forms of investment risk not captured by standard deviation.
The subsequent events and impact of late 2008 and early 2009 are well-known: The credit markets imploded, liquidity evaporated, all correlations (except Treasuries and CTAs) went to +1, and the markets came crashing down. CTAs generated positive performance in 2008 and hedged equity mitigated a portion of the downside movement in equities, but absolute return strategies absolutely failed to meet investor expectations. Broadly speaking, absolute return strategies posted double-digit losses—less than the global equity markets, but negative nonetheless. Worse, many of them faced enormous and untenable redemption requests that highlighted the mismatch of the underlying strategies and the liquidity terms of the FoFs. Investors were left dealing with partial redemptions, “gates,” and side pockets that meant it might be years before they got the balance of their money back.
To top it off, the Bernie Madoff scandal broke in December 2008. Madoff’s scheme wasn’t a hedge fund or an alternative investment, but hedge funds and alternative investments were vilified in its wake. In particular, investors developed an extreme aversion to the LP structure, which they now associated with illiquidity, lack of transparency, and lack of regulatory oversight.(4) Life was not good. See: After a wait, Schwab has a program for alternative assets
During the past two years alternative investments returned to normal performance and investors slowly are reallocating portions of their portfolios to the multitude of strategies now available. But where is the industry heading next? See: The alternative investments sales cycle for RIAs got longer but marketing patience got shorter
This article revisits the argument for including alternatives within diversified portfolios, keeping in mind the events of 2008–2009 while also applying a longer lens to historical performance. Trends and developments over the past five years now allow greater access to alternative strategies and dictate a different conversation with investors about their purpose, acceptable or unacceptable trade-offs, and appropriate ways to incorporate them in well-diversified portfolios.(5)
Just the Facts, Ma’am
Alternative investments performed well over the past 20 years, the events of 2008−2009 notwithstanding (see table 1). Since 1990, most hedge fund strategies have generated performance equal to or better than the S&P 500 or Barclay’s Aggregate Bond indexes with significantly lower volatility than stocks.(6) The time series is highly relevant: 1990–2010 spanned alternating extreme bull and bear markets for equities and was one of the most bullish environments for bonds in history.
Table 2 shows historical diversification benefits of alternative investments, highlighting the low correlations between most strategies and either stocks or bonds. Correlation coefficients are not static, of course, and during the perfect storm of 2008, most alternatives (with the notable exception of CTAs; see table 3) did not deliver the expected diversification or alpha-generation benefits for which they had been included in portfolios. In many cases diversified portfolios that included alternatives did not lose as much value as the broad equity markets. But a loss of only 15–20 percent—though the broad equity markets were down 30–40 percent—was cold comfort to most investors.
Absolute Return Strategies
It also is interesting to examine the three-year rolling performance of absolute return strategies (using the HFRI Fund of Funds index as a proxy) compared with bonds (see figure 1). Absolute return strategies outperformed bonds in most three-year rolling periods over the past 20 years with two notable exceptions: the bear markets of 2000–2003 and 2008–2009. What was common about those two periods? Both were precipitated by market crashes that compelled the Federal Reserve to drastically cut interest rates, which benefitted the total return of bonds.
The flip side of this dynamic is equally interesting. Given historical performance, investors might expect absolute return strategies to outperform bonds in rising-rate environments, and this has happened over the past 20 years (see figure 2). Since rates currently are at historical lows and eventually will move up, this may bode well for absolute return strategies going forward.
Hedged Equity Strategies
Hedged equity strategies tell a similar 20-year story (see figure 3). The objective of most hedged equity strategies is to participate in the general directionality of the equity markets while “cutting off” the highs and lows to deliver a more consistent performance over time. In particular, investors expect skilled long-short managers to protect capital in down markets.
Examining hedged equity performance in up markets and down markets illustrates this point. These strategies underperform in up markets, but this is more than made up for by dramatic outperformance in down markets (see figure 4).
A comparison of the (high) correlation but (lower) volatility of hedged equity with broader equity markets supports the hypothesis that hedged equity should closely track the general performance of the equity markets but with less volatility (see figure 5).
CTA (Managed Futures) Strategies
Commodity trading advisor (CTA) strategies invest primarily in liquidly traded futures and option contracts on commodities, interest rates, equities, and currencies. CTA managers may employ fundamental analysis to take long or short positions in these contracts or, more frequently, they employ technical analysis in an attempt to capture the upward or downward trends of the underlying price movements. “Global macro” is a specialized subset of the broader CTA market and refers to managers that make investment decisions based on large-scale macroeconomic, geopolitical, trade-balance, and business-cycle developments the world over.
These strategies have gained popularity over the past decade and with good reason. They are liquid and transparent, and historically they have shown almost no correlation to either the equity or fixed income markets (see table 3). Over the past 20 years they also have generated equity-like returns with lower-than-equity-market volatility. This has made these strategies important diversifiers within broader portfolios. Time horizon is an important consideration with CTA strategies: Over short periods they can exhibit high volatility because trends in underlying prices can reverse quickly.
Applying a longer time horizon, however, shows a remarkably different story. As shown in figure 6, in the past 20 years CTA strategies generated positive returns in every three-year rolling period. In some periods equities strongly outperformed CTAs, but in the bear markets of 2000–2003 and 2008–2009 CTAs added important ballast to diversified portfolios.
Putting It All Together
Having examined the individual cases for the inclusion of absolute return, hedged equity, and CTA strategies, it is useful to summarize how they work together within diversified portfolios. Figure 7 shows the growth of different portfolios over a 10-year time horizon.
Portfolio A shows the performance of the MSCI All World index (0.2-percent annualized return with a standard deviation of 10.1 percent).
Portfolio B shows the performance of a more-traditional portfolio consisting of 60 percent in the MSCI All World index and 40 percent in the Barclays Aggregate fixed income index (2.3-percent annualized return with a standard deviation of 10.7 percent).
Portfolio C shows a similar 60/40 portfolio with the equity allocation bucketed into large, small, micro-cap, value, growth, and so forth. This might represent a typical high-net-worth portfolio that includes no alternatives, and over the 10-year time horizon it generated an annualized return of 5.1 percent with a standard deviation of 12.8 percent.
Portfolio D is a fully diversified portfolio with allocations to traditional equity and fixed income as well as absolute return, hedged equity, CTAs, and other nontraditional strategies such as master limited partnerships and commodities. This portfolio generated an annualized return of 5.9 percent with a standard deviation of 10.4 percent.
The inclusion of alternatives in Portfolio D did not prevent losses in the 2008–2009 market collapse. Over the 10-year period, however, Portfolio D generated significantly better with volatility comparable to more-traditional portfolios. Standard deviation, of course, is a necessary but insufficient measure of risk (it does not measure risks such as liquidity, credit, and counterparty risk, for example), and the next 10 years may be significantly different from the past 10. That said, at least based on historical performance, the argument is strong for including alternative investments within diversified portfolios.
A common criticism of alternative investments (or, more accurately, of hedge funds) is that the short-term trading nature of many strategies makes them very tax-inefficient for taxable high-net-worth investors. Over the years, various tax strategies have developed that attempt to improve the tax characteristics of hedge funds (e.g., call options and warrants linked to hedge fund performance, private placement life insurance strategies, and so forth). Regardless of their merits, adoption has been low—the vast majority of investors seem simply to accept the tax-inefficient nature of hedge fund strategies. This may be due to the complexity or audit risk of some of the tax management strategies, or it simply may be the consequence of an investor base that focuses on pre-tax returns.
This pre-tax focus is echoed by the funds and managers themselves. Few, if any, hedge fund managers attempt to differentiate themselves on the basis of tax efficiency—the focus is almost always on net-of-fee but pre-tax performance. Until and unless tax rates rise sufficiently to drive investor demand for improved tax efficiency, this focus is unlikely to change.(7)
Summary and Conclusions
Investors need to determine what is appropriate for their portfolios based on their objectives, sophistication, liquidity constraints, and time horizons. Despite negative media and perceptions of the past two to three years, alternative investments have added value to well-diversified high-net-worth portfolios.
One interesting development in alternative investments has been the rapid growth and acceptance of mutual funds, regulated investment companies (RICs), and undertakings for collective investments in transferable securities (UCITs),(8) that is, highly regulated legal structures that invest in various alternative strategies. The market implosion of 2008 resulted in investor aversion to LPs, which is slowly abating.(9) See: The top 10 alternatives to alternative investments
Investors who wanted exposure to alternative investment strategies increasingly have turned to mutual funds or registered products. Given the investment and leverage constraints of these more-regulated vehicles, investors should not expect the same risk-and-return characteristics even if these strategies are managed similarly to an LP run by the same portfolio manager. Despite this, and despite the relatively short track records of most funds, many investors seem happy to exchange the potentially superior performance of an LP for the liquidity and greater regulatory oversight associated with mutual funds. Amounts of assets invested via LP structures still dwarf those of mutual funds, and direct investment into single-strategy LPs remains fairly strong. But in the future mutual funds most likely will cannibalize investment flows that might go into multi-strategy funds of funds.
The conversation between advisor and investor about alternative investments has changed. Given the growth of mutual fund products, an aversion to LPs is no longer a reason to avoid alternative strategies. Assuming that an investor’s sophistication and investment objectives warrant including alternative investments within a diversified portfolio, the conversation needs to focus on characteristics the investor expects and desires from that alternative exposure: What is the acceptable trade-off among performance, liquidity, leverage, and transparency?
One result of such conversations may be an eventual acknowledgement that “alternative investment” is an unfortunate misnomer; that the real discussion is about what constraints investors want on the construction and management of diversified—and ultimately pretty traditional—portfolios.
Scott Welch, CIMA®, is senior managing director of investment research and strategy at Fortigent, LLC, in Rockville, MD. He earned a BS in mathematics from the University of California, Irvine, and an MBA in finance from the University of Massachusetts Amherst. Contact him at email@example.com.
Robert Mileff, director of alternative investments, and Shaun Jones, alternative investments analyst, both from Fortigent LLC, contributed significantly to the content and editing of this article.
1 Throughout this article the phrase “absolute return” is used to describe investment strategies designed to have relatively low directionality (i.e., low correlation to equity markets) and that are supposed to generate steady, consistent returns with below-equity-market volatility. The alternative investment community, however, did itself and its investors no favors by coining the phrase “absolute return,” because the events of 2008 showed clearly that there was nothing absolute about the performance of these strategies. The term “diversified alternatives” is preferable because it describes what the strategies are rather than what they are supposed to do. But because “absolute return” is so firmly entrenched in the industry lexicon, it will be used throughout this article.
2 Industry growth statistics can be found in multiple sources, such as the HFRI Global Hedge Fund Industry Reports (available for purchase at http://www.hedgefundresearch.com/index.php?fuse=products-irglo); the Russell 2010 Global Survey on Alternative Investing (http://www.russell.com/uk/alts_survey2010/); the KPMG June 2010 white paper, “Transformation: The Future of Alternative Investments” (http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/Transformation-The-Future-of-Alternative-Investments.pdf); and “Results of the Credit Suisse 2010 Global Survey of Hedge Fund Managers’ Marketing Strategies” (March 2010), https://www.credit-suisse.com/news/en/media_release.jsp?ns=41450.
3 Alternative investments and hedge funds are not synonymous, though the terms frequently are used interchangeably by the media and investors. Hedge funds and limited partnerships are more closely related, and are not investment strategies at all—they are simply the delivery vehicles and corresponding compensation structures for many alternative investment strategies. The difference is more than just pedantic, as demonstrated by the rapid growth of alternative investment mutual funds, UCITs, exchange-traded funds, and exchange-traded notes.
4 Once again, it is important to be specific. CTAs generated positive performance in 2008 and most hedged equity strategies did not face either a lack of transparency or a lack of liquidity. While investors tended to lump all alternative investments together, it was primarily absolute return strategies that failed to meet investor expectations with respect to performance and liquidity.
5 This article focuses on relatively liquid alternatives—absolute return, hedged equity, and CTAs. Private equity and private real estate, as well as other more illiquid investments (e.g., timber) may have an appropriate role in diversified portfolios for many investors, but they are not addressed in this article.
6 Some readers may take issue with the use of the HFRI indexes in this comparison, citing the many inarguable weaknesses in the construction and representativeness of those indexes. That point is valid, but I defend this usage with an adaptation of Winston Churchill’s famous quote about democracy: “They are the worst indexes available, except for all the rest.”
7 For a more in-depth analysis of hedge funds and taxes, see Kim et al. (2011).
8 The UCIT is a European Union legal structure, similar to but not quite the same as an RIC and a mutual fund in the United States.
9 In response to the events of 2008, many LP managers improved the transparency and liquidity of funds and institutionalized due diligence, administration, and oversight efforts. These steps were positive, but the recently announced SEC investigations into insider trading, which encompasses both traditional and alternative investment managers, is likely to perpetuate the aversion to LPs. To date, very few funds publicly identified as targets of the investigations have been charged with any wrong doing and most have announced that they simply have been asked for information as part of a broader investigation. Regardless, the story is likely to feed the current media and political narrative that investors should be wary of “hedge funds.”
Kim, Robert, Edward H. Dougherty, and Miriam Klein. 2011. Will Hedge Fund Investors Start Asking for Tax Alpha? Can Hedge Fund Managers Deliver It? Journal of Wealth Management 13, no. 4 (spring): 44–50.
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