The narrative around “hedge fund underperformance” should be taken with many grains of salt. Three immediate questions an adviser should consider when addressing that question are: (1) underperformance relative to what — e.g., equity markets, other alternative strategies, investor expectations, etc.; (2) over what time frame are we evaluating comparative returns; and (3) what are the historical and prospective drivers of performance for hedge funds in relation to other return sources in traditional and alternative asset classes.
Assessing broad hedge-fund performance is quite challenging, as thousands of funds are spread across many uncorrelated investment strategies, and the inter-quartile spread between top- and bottom-quartile funds is far more significant in alternative strategies (e.g., private equity, private debt and hedge funds) than in traditional equity and fixed-income markets. That said, one reference for hedge fund performance is the HFRI Fund Weighted Composite Index, which includes a large universe of hedge fund returns across multiple strategies. With available data going back to 1990, the numbers depict the comparative performance and volatility characteristics of the HFRI index against the S&P 500 Index and Barclay Aggregate Index, as proxies for equity and fixed-
income markets, respectively, segmented by four
distinct seven-year periods. Key takeaways include:
- During each period, hedge funds outperformed fixed income with less than half the volatility of equities.
- During the first three seven-year periods (ended December 1996, December 2003 and December 2010), hedge funds outperformed equities by 300 basis points to 500 basis points on an absolute basis and, more significant, on a risk-
- Over the most recent period, through December
2017, hedge funds have underperformed
While much has been written about the drivers of this relative underperformance, we believe the most significant contributors have been the effects of historically low interest rates, quantitative easing and the global appreciation of risk assets at the broader index level. The three-month Treasury bill ranged from 3 percent to 5 percent for much of the 20-year period preceding the financial crisis, after which rates were effectively brought to zero.
One of the implications of this policy was an increase in cross-asset correlations and a lack of differentiation in security prices, fueling the rise of liquid, passive, long-only instruments. This trend, as it relates to interest rate increases and stimulative central bank policies, changed in late 2015 and has continued since, creating a much more conducive environment for strategies seeking a wider dispersion of outcome in securities that rise and fall for more idiosyncratic reasons. While “long and strong” has been the best strategy over the past seven or eight years, history suggests hedged strategies have delivered long-term outperformance.
With equity markets approaching year 10 of this historically advanced bull market, and with hedge funds having underperformed over much of that period, some investors are considering hedge funds only in the context of downside protection. It is true most hedged strategies outperformed equity markets substantially in 2000–2002 and again in 2008, with certain strategies delivering positive performance in one or both periods, during a time when equities declined by 40 percent to 50 percent. Looking forward, it is critically important to understand the drivers of returns that underpin hedge fund strategies, as opposed to evaluating past performance in the context of a changing market environment.
As referenced above, there have been periods that can be categorized as high-, moderate- and low-
return environments for U.S. equities, with the S&P 500 Index annualizing at roughly 14.4 percent, 7.6 percent and 3.9 percent over those distinct seven-
year periods. Interestingly, while hedge funds outperformed in each period, the largest performance differential occurred during the 1990–1996 period, when the S&P 500 Index delivered mid-teens returns to investors, and hedge funds outperformed by 500 basis points. The worst of those three periods from a comparative performance standpoint was 2004–2010, with hedge funds generating 6.8 percent returns versus S&P 500 Index returns of 3.8 percent. Based upon previous periods of high/low equity performance, hedge funds performed best when equities were up the most.
So, hedge funds outperformed during up markets and protected capital in down markets, but they have underperformed over the past seven years. What, then, are realistic expectations for future hedge funds performance relative to stocks and bonds? In short, most hedge fund strategies are not “short the market.” Instead, they are effectively short correlation and long dispersion, meaning an era of extremely high correlation and low dispersion is the worst environment for most hedged strategies.
From 2010–2016, we saw a seven-year period of exceptionally high correlations (assets moving in near lockstep) with historically low dispersions (narrower range of outcome). Since December 2015, we have seen a nearly two-year period of rising interest rates, first in the United States and more recently across the globe, which has coincided with a precipitous decline in cross-asset correlations.
Effectively all hedge fund strategies require some level of price dispersion, benefitting from lower correlations within and across asset classes globally. Although the 2010–2016 environment was dominated by central bank policies and various forms of quantitative easing, the past two years have seen a paradigm shift toward new return drivers. Unsurprisingly, the performance of many hedged strategies has picked up considerably over this period. Against the backdrop of “expensive” stocks and bonds, this differentiated performance serves an increasingly significant role within a diversified portfolio.
Joseph Burns is managing director and head of hedge fund due diligence at iCapital Network.