Tuesday, May 17, 2016

Can We Predict Forward Alternative Investment Performance?

My friend Ben from A Wealth of Common Sense poses the interesting question, How Should Alternative Investments Be Benchmarked? Please go read his post for a number of interesting thoughts on that topic. In this post, rather than rehash his arguments, I'll go a different direction and articulate what drives the performance of alternatives (i.e. hedge funds / liquid alts) to see if we can predict forward performance (which in a backwards way, may provide some insight into how an investor might think about benchmarking performance).

Low Interest Rates = A Headwind for Absolute Hedge Fund Performance

What's interesting to me is that one of the main reasons I regularly hear why investors are allocating to hedge funds, is actually a reason why hedge fund performance has been so disappointing. Back to Ben's post for a specific example in the form of a comment from his reader (bold mine).

Interest rates are too low and stock market volatility is too high so we have to hold some alternatives in our client portfolios. 
Low interest rates are actually a reason not to own alternatives. People seem to forget that alpha is a "cash plus" return stream. The excess performance of a hedge fund (with 100% of returns driven by alpha) will be a certain %, which added to the cash rate gets to the total return generated by the hedge fund. The same skill that generated a 10% hedge fund return when cash rates were 5% (5% alpha + 5% cash), only generates 5% when cash rates are 0%. As a result, all else equal, the lower the cash rate, the lower the relative performance of hedge funds.

Predicting Alternative Investment Performance

While interest rates are an important consideration when making an allocation to an alternative manager, they are not enough to predict future relative performance vs a traditional stock / bond allocation. One key is to look at the level of risk premia (both stock and bond risk premia).

Risk premia is:
The difference between the expected return on a security or portfolio and the "riskless rate of interest".

In my analysis I calculate the expected return on stocks and bonds as follows:
  • Stocks: CAPE yield (1/CAPE) - Source
  • Bonds: Long Term Bond Yields - Source
I then subtract out the riskless rate of interest (which I define as the average 7 year forward t-bill yield) to get the premia, while the 40/60 blend is a 40% equity risk premium / 60% bond term premium blend (given the average hedge fund beta is ~0.40). In this analysis, I forecast future cash rates moving up 50 bps / year to 2% and staying there (more on this later) to get the stock and bond term premia for forward years that have not yet occurred.

In terms of predicting alternative fund vs. stock / bond performance, the opportunity cost of allocating to a hedge fund is largest when these premia are high and lowest when they are low (or negative). As you can clearly see from the chart above, stock and bond risk premia were very low in the late 1970's / early 1980's when cash rates were elevated, high in the mid 1980's when Volcker was able to control inflation pushing down cash rates, subdued in the 1990's when stock valuations got extended, then huge in the mid to late 2000's after the financial crisis that pushed stock valuations lower and cash rates to 0%.

Given the above framework, you can see how the mid 1990's were a great time to be in hedge funds from both an absolute perspective (cash rates were high) and relative perspective (the equity risk premium was low), while the exact opposite situation has been true for the last 7+ years. The chart below takes the above starting risk premia levels since 1994 and plots them against the relative forward performance of the Credit Suisse Hedge Fund Index (I can only get returns starting in 1994) vs. a 40% stock / 60% allocation.

What Can We Predict from Here?

Given this analysis, it appears the opportunity cost of hedge funds is once again approaching "fair value" given the much lower bond term premium, BUT an allocation will be largely dependent on an investors view of the direction of cash rates. It is less important to relative performance whether cash rates are currently low, but whether they will stay low. Should they move much higher than the 2% modeled in my analysis, then now may actually be a good time think about alternatives.