Friday, July 29, 2016

The Case for Hedge Funds / Creating an Ideal Liquid Alt

A hedge fund is simply a go anywhere investment vehicle that attempts to provide excess returns to cash with a low correlation to traditional asset classes (i.e. they are vehicles that attempt to provide alpha). Hedge funds and liquid alternatives have taken a lot of heat recently, much of it deserved, but in this post I'll outline the case they are being incorrectly evaluated. Specifically, this post will outline the benefit of a hedge fund that can provide excess performance to cash with low correlation to stocks / bonds even if it provides only a minimal level of excess return. In addition, I will share how an investor can effectively utilize a hedge fund (or liquid alternative) within a broader portfolio, which will touch upon why hedge funds should rarely be judged by their level of absolute performance.  

Why Have Even the Best Hedge Funds Disappointed Investors?

The below equity curve is for the actual returns of a hedge fund, which I'll label Hedge Fund X, that I pulled specifically because the since inception returns have:
  • Consistently been uncorrelated with those of stocks (0.13) and bonds (-0.10)
  • Been in excess of cash
  • Underperformed a 60/40 portfolio

In other words, Hedge Fund X has had very strong risk-adjusted performance, yet has provided only average absolute returns when compared with stocks and/or bonds. As a result, an investor that reallocated from stocks and bonds to fund the allocation to Hedge Fund X wouldn't have accomplished much. While the allocation did improve risk-adjusted returns of the overall portfolio, it came at a lower overall return and (as the chart shows below) it hardly moved the needle in terms of the return path. Given the amount of incremental due diligence required to make the allocation and the high fees paid (which can now make headlines for public investors), there may be buyer's remorse for the allocation (this despite the luck that was likely involved in finding a hedge fund that was able to produce such remarkable risk-adjusted performance ex-post).

The Case for Leverage: Hedge Funds as an Alpha Overlay

Rather than carving out an allocation to a hedge fund from stocks and/or bonds, an investor can make an allocation while maintaining their broader asset allocation through the use of leverage. The resulting economic exposure can be viewed as a traditional beta portfolio with the hedge fund as its alpha source. The structure could be created a number of ways, including selling out of stocks and overlaying stock futures over the existing bond portfolio (an example of a mutual fund that does that here). The end result is a strategy that provides an investor with a fully invested exposure to a stock / bond allocation using only 50 cents on the dollar, freeing up proceeds for Hedge Fund X with the remaining 50 cents.

Using a hedge fund as an alpha source is typically performance enhancing as long as the hedge fund outperforms the investors borrowing cost (i.e. cash rate, which is currently ~0%) net of fees. This may provide an investor the ability to reduce the risk of the underlying beta portfolio without reducing the expected return of the overall portfolio. In the example below, the stock allocation was reduced to a "less risky" 50% allocation, yet the combined portfolio was still able to outperform a 60/40 blend on both a risk-adjusted and absolute return basis due to the incremental return provided by the Hedge Fund X.

A performance comparison since the financial crisis may be more interesting as this has been a period in which the absolute return of Hedge Fund X has materially lagged. This has been driven by the strong performance of stocks and bonds (allocating away would have been a huge opportunity cost in hindsight) and due to the low level of yield on cash (see here for more details as to why that's a drag). Since the March 2009 bottom, Hedge Fund X returned only 4.4% annualized (underperforming the 18% return for the S&P 500 and the 4.8% return for aggregate bonds), yet the allocation utilizing Hedge Fund X as an alpha overlay continued to add value in the form of higher returns and lower risk when utilized with a 50/50 beta portfolio. 

Hoping for Innovation in Liquid Alternative Space

As outlined above, the real benefit of using uncorrelated return streams often comes if they are utilized as an alpha enhancer via an overlay, especially true in the current environment as financing costs have a low hurdle rate of ~0%. This benefit becomes a challenge for liquid alternatives that are structured as "cash plus" investment vehicles as record low cash rates are a drag to performance (rather than a low hurdle). As a result, my hope is the industry moves back towards an alpha / beta model that was popular pre-crisis where investors can gain access to cheap beta within the fund itself. Better yet, perhaps as an alpha overlay over a dynamic beta structure that has a historical track record of outperformance.