Finding Unique Return Streams
By: Keith Tomlinson
Pension plan funding surpluses and shortfalls tend to vary with longer-term interest rate assumptions and plan beneficiaries’ life expectancy assumptions on the liability side, versus actual and assumed rates of return on the asset side. Linking these factors with alternative strategy return components can create diversification benefits for traditional portfolios. These diversification benefits include both higher potential returns and lower total portfolio volatility.
It is impossible to know precisely how assets classes will perform over the next 10 years. However, an examination of the return components (dividend and current bond yields) suggests that these returns will be much less than that of the past 10 years. Low expected returns are a difficult starting point for investment decision-makers today, particularly when liabilities can respond to macro variables so differently than assets. Hedge funds can help improve asset liability matching because the return components are different than traditional stocks and bonds.
BCA Research estimates expected equity returns, using the S&P 500, for the next 10 years will range from two to seven per cent per year1. The mid-point of this estimate is about five per cent. Similarly, the current yield on 10-year US Treasury Bonds is about 4.4 per cent. Higher returns may be available in global markets, although the cost of hedging (or not hedging) currency rate differentials, may act to reduce or eliminate these higher returns. Low real interest rates seem to be a global phenomenon at the moment. The challenge is that a significant equity market decline would be difficult to recover from in a low return environment.
Hedge fund returns have trended down over the past five years and are sub-par this year, although many major equity markets have failed to recover their peak values over the same period. A look at the components of hedge fund returns demonstrates why these returns have trended down and why these unique return streams remain a useful diversification tool.
A June 2005 research report from Edhec Risk and Asset Management Centre offers a surprising, but important, summary of hedge fund returns: “The essential part of hedge fund performance comes from their beta. Their talent resides in the management of those betas2.” Indeed, it is the very fact that hedge funds expose investors to alternative ‘betas’ or risk factors (those other than traditional passive equity and bond market exposures) that makes them so valuable from an asset allocation perspective.
Specifically, Edhec found that hedge fund returns could be looked at as having three components:
- pure manager skill expressed through security selection. This is commonly referred to as ‘alpha.’
- a traditional passive ‘beta’ or exposure to the market risk of a particular asset class.
- an alternative or dynamic ‘beta,’ which can be thought of as a timing or trading decision for exposure to specific risks such as credit, liquidity, volatility, or commodity prices.
This dynamic beta is the primary characteristic of hedge fund performance and, when combined with a manager’s security selection skills, amounts to the ‘total alpha’ or return above that explained by market exposure alone.
Consequently, the large numbers of managers that have entered the market are not depressing pure ‘alpha,’ but rather are constrained by their ability to time or trade factors successfully. Investors should, therefore, understand how a manager’s capacity impacts their ability to trade. Generally, smaller is better. Furthermore, it is the current state of these factors (low equity volatility, high correlation, and credit spread widening) that have conspired to depress hedge fund returns and not ‘alpha’ reduction or a lack of skill. Put simply, the trading opportunities are significantly reduced.
So why allocate to hedge funds? A look at the various hedge fund strategies will provide an answer to this question. Hedge Fund Research Inc. reports that total hedge fund assets under administration to June 2005 are US$1,025 billion and have more than doubled since 2000. Equity long/short and event driven strategies are more than half of this total and are more than half of new hedge fund asset flows this year. Conversely, convertible arbitrage and equity market neutral have seen substantial outflows. Investors clearly favour equity hedge and event driven allocations over convertible arbitrage and equity market neutral.
It might be helpful at this point to try to link the factors that affect pension surpluses and shortfalls with alternative ‘betas.’ Higher long-term interest rates would help to reduce the liability side of many pension plans, although they might also cause higher volatility or declines in certain investments on the asset side.
On the other hand, a hedge fund strategy such as convertible arbitrage, which has been very topical this year, is helped by volatility. In volatile 2002, the strategy performed well. Today’s low volatility has contributed to the current drawdown. For hedge fund investors, dynamic or managed exposures, long and short, in the various securities markets globally is about emphasizing these trading returns rather than pure security selection returns. Hedge fund investors often allocate in, say, fixed income markets on a ‘market neutral’ basis. That is, their long and short exposures are nearly perfectly balanced. Our preference is to give managers the flexibility to invest net long or short, depending on where they see opportunity. In a fund of hedge funds, manager diversification keeps volatility low and there is little meaningful correlation with broader markets. But this is a portfolio effect rather than the goal of each individual allocation. Overall, we believe it is increasingly important to emphasize the role of manager trading decisions.
As such, we believe the manager selection process is paramount. The most important decision is to find unique and interesting hedge fund managers of reasonable but not excessive asset size to invest with in an under-researched asset class. For example, many Japanese equities, particularly mid caps, have no analyst coverage. So Japanese equity long/short is a promising strategy currently. At the same time, certain hedge fund strategies are facing headwinds this year – convertible arbitrage and longterm trend following CTAs, for example – where there are a considerable number of skilled managers already invested.
Convertible arbitrage has lost money for many hedge fund investors this year. The current climate is, however, somewhat of an opportunity as, once the redemption driven forced selling abates, convertible arbitrage investors will be able to benefit from the positive carry currently available as well as the ‘free put’ stemming from the long convertible bond/short stock portfolio structure. This is particularly attractive to equity investors. Another major issue for hedge fund investors this year lies with the continued low market volatility and high correlation pattern, which has proven difficult for many strategies, such as volatility arbitrage and equity market neutral. At the same time, many of these managers are perfectly set up to do well should the broader equity markets sell off suddenly.
We believe the solution to the problem of generating stable returns in a low return environment involves investing on a global basis to take full advantage of the potential of emerging markets, while, at the same time, hedging out, or indeed profiting from, periodic market dislocations. The huge changes in the global economic landscape, stemming from the industrialization of India and China as well as Japan’s recovery, are no doubt going to create winners and losers in every asset class and industry around the world. But these trades will necessarily require a different approach than the ones that benefited from the now defunct trends of the past 20 years – declining interest rates and rising equity valuations. Hedge funds are uniquely positioned, by investing both long and short, to benefit from these significant macro economic changes.
However, hedge fund investors should perhaps focus on managed or flexible beta (market exposure) rather than none at all. The nature of this managed exposure, long and short, varies by geography and strategy as the hedge fund manager constructs their portfolio to best tackle their respective markets. Additionally, a fund of hedge funds can manage strategy allocation, based on the idea flow of each manager and a bottom-up risk assessment. Above all, it is important to avoid crowded trades by working with smaller more nimble managers who can access areas of their markets not available to larger players and thus provide the full benefits of managed ‘beta’ or active trading decisions.
Hedge fund performance characteristics are, therefore, helpful to an investor with a traditional balanced equity and bond portfolio. Expected returns for these investments look modest and yet considerable macro risks could cause periodic market corrections. Recovery from these declines may be difficult and, in fact, many equity indices remain below their peaks of five years ago. Helpfully, the risk factors that affect hedge fund performance do so in a way that is often directly, rather than inversely, related to an investor’s liability considerations.
Looking ahead, we believe there exists a number of exciting long-term investment themes in the world including Asia and emerging markets. These have also led to related investment opportunities in energy and commodities. Indeed, there is a significant shift underway in the global economy, which we view as broadly positive. But we also believe these trends are often best addressed with a hedged portfolio. It is important for investors to only take risks for which they will be compensated. The rest should be neutralized or hedged. This is a dynamic process, which is why we prefer flexible beta, or market exposure, as opposed to an effort to have no beta, which may not be desirable in today’s markets.
Keith Tomlinson is director of research at Arrow Hedge Partners Inc.
1. “Investment Strategy for a Low Return World,” BCA Research (November 2004), 19.
2. “The Right Place for Alternative Betas in Hedge Fund Performance: An Answer to the Capacity Effect Fantasy,” Edhec Risk and Asset Management Centre (June 2005), 1.
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