Hedge Funds And The Economic Cycle
By: Jeffrey Erickson
It’s not enough simply to decide to use hedge funds and expect absolute returns. Investors must assess the economic cycle and find hedge products which are best-suited to those conditions. Jeffrey Erickson, of Mirabaud Group, looks at which strategies work best under different conditions.
Three years into the financial bear market, institutional investors are increasingly considering allocations to hedge funds. Generally speaking, hedge funds are supposed to be absolute return investments and should, at least in theory, produce positive returns regardless of where we are in the economic cycle.
The fact of the matter is, however, that many hedge funds have not been able to perform in the current bear market. The HFR Composite Weighted Index ended 2002 down 1.5 per cent, its first annual loss in 12 years. Returns in different styles ranged from +8.98 per cent in convertible arbitrage and +7.46 in global macro to - 4.75 per cent for long/short equity.
The question to ask is whether a strategic allocation to different hedge fund strategies in different stages of the economic cycle adds any value to a portfolio of hedge funds.
One of the first challenges encountered is the economic cycle itself. Where are we in the cycle right now?
As you might recall at the end of 2000, six months into the current bear market, most specialists were talking about a Vshaped recovery. At the end of 2001, consensus was for a U-shaped recovery. Today it looks more like an L-shape and no one can predict when that recovery may occur.
A second challenge is the correlation of a hedge fund style to the equity and fixed income markets and, more specifically, the stability of the correlation over time. Ideally the correlation should be as close to zero as possible and remain stable over time.
Unfortunately, if we look back over the last 10 years, we notice that this is not the case. Of different strategies, equity hedge has the most stable correlations to equity markets over time ranging from 0.4 to 0.8 over the period with an average correlation of around 0.6. Other strategies show little stability. Event driven and relative value strategies show correlations swinging from a negative 0.1 to 0.8 over the same period.
In addition to correlation to the equity markets, it is important to consider other financial and macro-economic factors and look at how they influence different hedge fund styles. This brings a better understanding of which strategy works best in a specific macro economic environment. Different studies have been made in this area and some of the factors used in different models are:
- Slope of the yield curve – the difference between the YTM of the 30-year Treasury bond and the three-month T-bill rate as well as their current yield
- Volatility measurements, such as the intra-month standard deviation of the S&P 500, implied volatility of the index for equity options (S&P100), and the intra-month volatility of bond returns
By taking into account these different macro economic factors, we will have some additional tools to explain performance in different hedge fund styles that are not ‘equity dependent’ and where volatility impacts as well as potential arbitrage and the main credit risk factors.
From a relatively simplistic perspective, the following observations can be made:
- Long/short equity works best in the recovery phase of the cycle
- In the boom phase/top of the cycle, merger arbitrage should be favoured
- In the slowdown phase, distressed securities work best
- Market neutral and different arbitrage strategies should, at least in theory, work in any part of the cycle but are difficult to disassociate completely with interest rates.
So let us look at four different hedge fund strategies:
- long-short equity
- global macro
- convertible arbitrage
- fixed income arbitrage and see how they perform during different periods of the economic cycle taking into account not only the influence of the equity market but also including the macro-economic factors mentioned.
This strategy is, in reality, a multitude of different strategies. It includes long-biased managers, market neutral managers, and short sellers.
Over the long term, the universe of long/short equity managers tends to be on average 20 to 25 per cent net long. Correlations, although more stable than for other strategies, tend to be higher versus different equity indices.
The strategy tends to perform best when the equity markets perform well. A moderately upward sloping yield curve, indicating a growing economy with low inflation – coupled with declining volatility and declining risk premiums on equities – are factors that should indicate performance above historical averages.
This is a general guideline for long/short equity managers with a long bias. Market neutral and short sellers would not perform in the same way indicating that a general hedge fund classification has to be disaggregated and made as ‘strategy pure’ as possible before any analytical work is done.
The global macro managers have some similarities to the equity long/short strategy although, in general, they have a higher exposure to the bond market and use systematic trading of forwards, futures, and options in currencies and commodities.
This strategy performs well when short-term rates are at a low level and are not increasing.
The strategy is less sensitive to the direction of equity markets as interest rates tend to be negatively correlated.
This strategy generally performs less well, however, when the intra-month volatility of the S&P500 and the implied volatility index are high or are increasing.
Managers in this strategy are long the convertible bond and short the underlying equity security. It’s a strategy that likes moderate volatility but not low interest rates.
A negative for convertible arbitrage strategies is raising short-term interest rates as well as high and rising long-term bond rates.
Fixed Income Arbitrage
A steep positive yield curve with high long term rates is the ideal market for fixed income arbitrageurs giving them the possibility to be long the long end of the curve and short the short end of the market.
Further, the strategy performs well when credit risk premiums are high or when they are decreasing.
The strategy does not like moderate short-term rates that are decreasing or high yields on large cap stocks.
Graph 1 shows the performance of the five different strategies from 1988 to 2002 including two years of a momentum driven bull market followed by the three years of an equity bear market.
Given this information, is it possible to execute successfully a strategic style allocation over time? Many hedge fund of funds use a two-tier system where 40 to 50 per cent of assets are allocated to a portfolio of core managers that are supposed to perform under all circumstances and then make strategic investments according to the prevailing market conditions. Others try to build their portfolios as a ‘pool of talent’ by investing with outstanding managers and not trying to follow any specific guidelines as to allocation between styles.
There are, however, a few factors that will make it very difficult to execute the strategic style allocation.
One is liquidity. Some funds have quarterly or yearly liquidity in their funds and other funds can have long lock-up periods or early redemption fees making it impossible to quickly react and change a manager in a fund of funds format.
Furthermore, when you have fund of funds with a long track record, you will eventually end up with a large portion of your best managers being closed to new money. These managers are typically the most successful and it would be unthinkable to redeem your best performing managers because of a short-term strategic allocation decision.
Market timing and assessment is critical as failure to identify significant turning points in the cycle would render dynamic allocation irrelevant or even counter-productive.
The last reason, that has already been mentioned, is that the different sub-strategies are not style pure. Managers within the same strategy invest differently and their performance will not always be correlated to their peers. As a matter of fact, from a diversification standpoint, finding uncorrelated managers, working differently within the same style, is beneficial in limiting the volatility of the overall portfolio.
It is important to understand different macro-economic factors determining the performance of individual hedge funds, but building fund of funds portfolios can be rather simple. By investing in strategies that you understand well, taking a longterm view, and investing with managers who have shown the capability of making money no matter what the market conditions, this kind of portfolio can be built.
Even more important, however, is the investment in people. Long-term performance is a direct result of talent, methodology, and discipline. By striving to fully understand fund manager discipline and adding value by combining various skills and ‘edge’ together, consistent absolute performance over time can be achieved.
Jeffrey Erickson is first vicepresident, funds/research, of Mirabaud Group (www.mirabaud.com).
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