Despite recent high-profile exits from hedge funds and alternative investments, public pension funds are expected to be the main driver of growth in the alternatives space going forward. The combination of high interest and controversy around hedge funds and their managers has fueled the misperception of the role of a hedge fund allocation in an investor’s portfolio.
As institutional investors’ footprint in hedge funds has grown dramatically over the past several years, many of these investors might need to reassess and educate themselves on how hedge funds as a whole fit into their portfolio vs. their investment goals. We believe the drive into hedge funds by institutions has been prompted by their desire for diversification, bond-like volatility and low correlation to traditional long-only assets. Now, when a majority of institutions are either underfunded or stretching to meet their annual spending needs, the ability to generate bond-like consistent rates of return, lower volatility returns from equities and absolute returns to meet their financial obligations would be optimal.
To accomplish this, investors should seek out those strategies that employ conservative gross and modest net exposures, moderate levels of leverage and have proper diversification in regards to percent of assets within a particular asset class, industry group, and individual positions. Hedge funds that typically have these characteristics are long/short market-neutral equity and multistrategy funds. Institutional investors seeking higher returns, such as competing with and outperforming the Standard & Poor’s 500 index, should gravitate toward funds that can run with high gross and net exposures, will take directional positions and can employ various levels of leverage. Strategies fitting this model include long/short equity hedge, distressed/high yield debt and macro/CTA and are described in our strategy universe as return-generating.
“Hedge funds” are rarely identified by their particular strategy or characteristic, but are often perceived as one strategy unilaterally designed to beat the S&P 500 or other long-only equity index. In reality, hedge fund strategies are managed against specific absolute-return objectives or risk characteristics, and not always against a long-only benchmark. The objectives, costs, complexity and risk profile of each fund varies widely. Additionally, the percentage of a client portfolio allocated to hedge funds must be of sufficient size to have a meaningful impact on returns, while capacity to many high-performing funds is limited – meaning the largest pension funds cannot efficiently execute an effective hedge fund program. These issues add to the complexity and perceived exclusivity of alternative investments.
Over the years a number of excellent academic studies by Matthieu Bussière, Marie Hoerova and Benjamin Klaus (2012) and Amir Khandani and Andrew Lo (2007) have provided insights into the risk and return drivers for hedge funds. In these studies through principal component analysis, the authors have identified factors such as equity exposure, volatility and liquidity as being primary determinants of hedge fund returns.
Long/short equity is a strategy where the investment manager takes a long or short position in equity securities that are deemed to be undervalued or overvalued. Managers, depending upon their risk/return objectives can run portfolios with various ranges of gross and net exposures, typically net long but in the off occasion, net short as well. The net exposures tend to be in the range of +10 to +40% net. The following chart explains why these strategies do well in ascending markets, albeit with lower volatility — but do not necessarily exceed the return of the S&P 500.
In analyzing the impact interest rates have on long/short equity returns, we need to understand the concept of the “short rebate.” When a portfolio of short equities is established, equities are sold creating a cash balance in the manager’s portfolio account. The cash that is generated earns interest in the form of a “short rebate,” which is paid by the brokerage firm where the manager’s account is domiciled. The level of interest paid on the account is typically tied to short-term interest rates as defined by the broker call of fed funds rates. The effect on hedge fund returns in an environment when interest rates are high and can be substantial. As illustrated in the chart below, during the periods in 2005 and 2006 when fed fund rates were in the 4% to 6% range, a long/short manager would have that level of interest income to supplement the returns generated from the equity holdings. It is much easier to generate a 10% annual rate of return if you begin with a solid return from interest income. However, from 2009-2013, the “short rebate” has not contributed to returns.
The return of long/short equity is also affected by levels of volatility. These types of hedge fund strategies need a consistent level of rational volatility in order to generate alpha, as they profit from the price dispersion between stocks on a regional, sector and intramarket basis. The price dispersion in order to be additive to performance must be driven by fundamental factors, thus we term these markets to have rational levels of volatility as measured by the Chicago Board of Options Exchange Volatility index that is associated with the S&P 500 index options, which normally range from the 15% to 25% level. These levels of VIX volatility attempt to predict the potential price movement of the S&P 500 up or down by the percentage level over the next 30 days.
During the market debacle of 2008 when the VIX rose to irrational levels, equity prices were driven by global economic and macro factors as opposed to fundamentals, thus this irrational type of volatility will detract from the performance of long/short equity strategies. Similarly, other periods of irrational volatility in 2001, 2002, 2010, 2011, which are highlighted in red on the chart below, coincided with sharp dips in the performance of long/short equity strategies.
In summary: Equity hedge strategies tend to do well in ascending equity markets, albeit with lower volatility, as well as in rising interest rate environments and in rational volatility environments.
Over time we have found that the addition of hedge funds to a traditional long-only equity and fixed-income portfolio can reduce the downside variability of return, while increasing the probability of the institution meeting its annual return objective by effectively reducing the left tail risk of the portfolio. The ability of hedge funds to provide downside risk protection and improve consistency of return for a traditional portfolio, is by virtue of their low correlative nature to long-only assets. This effect was illustrated during the 2008 global financial crisis, as equity markets represented by the S&P 500 and the MSCI World index lost 36.99% and 40.71% respectively, according to Morningstar Inc. By comparison, the HFRX Global Hedge Fund Index was down less, 23.25%. With this history, we are comfortable at recommending upward of a 20% allocation to hedge funds to achieve this goal.
Institutional investors today are confronted with the need to both achieve consistent positive rates of return and mitigate downside risk. A number of public pension funds in the current low interest rate environment are seeing their underfunding status worsen. According to Loop Capital, which has been compiling pension data since 2003 with a database now covering 247 individual state and local pension funds from all 50 states, as of fiscal year 2013 the aggregate funded ratio for these state plans is only 73.1%. There are a number of large state plans that have a funded status of only 40% to 60%, and it is estimated unfunded liabilities of these public plans exceed more than $2 trillion in the U.S. The present funding status is still far below 100% despite rallying equity markets. For example, the S&P 500 is up more than 300% after hitting bottom at 676.53 on March 9, 2009, and reached its all-time high of 2071.46 on Nov. 21, 2014. Therefore, it is important for institutions to ferret out and employ investments that can meet their targeted rates of return without taking on an inordinate amount of risk.
Tim Ng is chief investment officer of Clearbrook LLC.