By Don Steinbrugge, CFA
There is a constant flood of articles in the media articulating that hedge funds have performed badly because they have underperformed the S&P 500 index. Many of these articles suggest that it is just a matter of time before investors wise up and begin redeeming from these over-priced investments. However, contrary to these stories is the fact that hedge fund industry assets continue to reach all time record highs. February hedge fund asset inflows were the strongest monthly inflows since before the 2008 market correction. In addition, in recent industry surveys a majority of institutional investors were happy with their hedge fund portfolio. Where is the disconnect between these articles and the attitude and behavior of many of the most highly sophisticated institutional investors that are responsible for a majority of assets flowing into the hedge fund industry? AIMA recently wrote a very good paper addressing this issue. We agree with most of their points, and have described Agecroft Partners’ additional market observations below.
What is missing is that these institutional investors are not using the performance of the S&P 500 as a benchmark for their diversified multi-strategy hedge fund portfolio because hedge funds are not an investment asset class. They are a legal structure that represents a highly divergent group of strategies, many of which have little to no equity exposure. Comparing the average hedge fund to the S&P 500 is similar to comparing the average mutual fund to the S&P 500. Investors don’t compare Vanguard’s money market funds, or PIMCO’s total return bond funds to the S&P 500 index for obvious reasons. So, why should anyone compare a hedge fund portfolio consisting of CTAs, global macro, structured credit, market neutral equity, distressed, event driven, volatility strategies, and long/short credit managers with the S&P 500? This brings us to the question of why are institutions increasing their hedge fund allocation and what are they using to determine if they are happy with their performance?
Typically, pension funds meet annually to determine what their asset allocation should be going forward. For each component of their asset allocation, they forecast an expected return, volatility, and correlation, and compare these with other components in the portfolio. These assumptions are based on a combination of long term historical returns for an asset class, current valuation levels, and economic expectations. Once all assumptions are determined, these variables are run through an asset allocation optimization model to determine the optimal asset allocation with the highest expected return for a given level of volatility. A diversified hedge fund portfolio adds value to these portfolios in several ways. They have a low correlation to long only benchmarks, which can improve portfolio diversification and potentially provide downside protection during a market selloff. Most important is their ability to enhance the forward looking return assumptions of the overall portfolio. Most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds which compares very favorably to core fixed income, where the expected return is only 2.5% to 3.0%. As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.
Since most of the new flows into hedge funds are coming from fixed income and not equity portfolios, many institutional investors in the short term will be happy if their hedge fund portfolio outperforms their fixed income portfolio, validating the decision they made. Others will be happy if their hedge funds outperform the forward looking return assumption they used in their asset allocations model. In both of these cases they were happy in 2013, because Barcap Aggregate Bond Index was down approximately (2.1%) in 2013 while the average hedge fund was up 7% to 12% depending on what index you use. Below are some other ways to evaluate a diversified hedge fund portfolio. It is important to remember that, since most hedge funds hedge a portion of their market exposure, all benchmarks are more accurate comparisons over longer time periods.
Risk-adjusted returns. The main objective of most investors is to get the highest return for a given level of risk and the most common way to measure this is by calculating the portfolios Sharpe Ratio. This statistic is commonly used by individual hedge fund managers and fund of funds, but rarely used by hedge fund investors to analyze their overall hedge fund portfolio. The hedge fund industry as reported in a recent article by AIMA has significantly outperformed long only benchmarks on a risk adjusted basis over time. It is also the most fair way to compare the performance of a portfolio because it equalizes the return generated based on the level of risk taken.
Tailored blend of global stock and bond market indices. Since hedge funds are a legal structure consisting of a diverse group of strategies, investors’ hedge fund portfolios can be highly divergent in their allocation to various hedge fund strategies. Some only invest in equity related strategies, while others may have no equity market exposure. Investors should consider using a blend of various long only indices that most closely match their underlying portfolio.
The media is always going to need a simple benchmark they can use on a monthly basis to report how hedge funds are doing. I would suggest they switch to a 60% blend of the MSCI All Country World equity Index and 40% of the Barcap Global Aggregate Bond Index. There are a lot of flaws with blending these 2 indices as a benchmark for the hedge fund industry; however, it is simple and would be an improvement over just using the S&P 500. The 60-40 split is also the approximate asset allocation pension funds used before diversifying into alternatives.
Risk-free rate plus 4% to 5% hurdle rate. Before 2008 this was a very common benchmark used for diversified hedge fund portfolios and is a good benchmark for hedge fund strategies with little or no market exposure (beta), and a bad benchmark for strategies with a lot of market exposure. Unfortunately, most strategies have a fair amount of market exposure. This benchmark led to a large disconnect between investors’ perception of how hedge funds should perform, and the reality of how they actually performed during the major market correction in 2008. Many investors did not expect to experience negative returns which led to heavy redemptions in the fund of funds industry.
Tailored benchmark at the fund level. The best way to evaluate hedge funds is at the fund level, where a customized benchmark can be used based on their strategy. For example, it is very appropriate to compare a long/short equity manager to an equity index like the S&P 500 over a rolling 3 and 5 year time period. However, if the fund can invest in small cap stocks along with non US equities, it makes more sense to use a global index that includes all market caps.
Hedge fund indices. Comparing a hedge fund portfolio to a hedge fund index is a useful tool to evaluate the quality of the manager and strategy selection. There is a broad array of hedge fund indices that can be used which record a broad return for the industry, and also show the return broken down by market strategy. The main issue with hedge fund indices is that there are large differences in their reported performance. The first issue all hedge fund indices have is getting hedge fund managers to report their performance to them on a monthly basis. Many hedge funds do not report their performance to hedge fund indices and of those that do, most only report to a few databases which creates discrepancies among the composition among various hedge fund indices. However, the main driver in dispersion of performance across hedge fund indices is how they are constructed.
1. Equally weighted verses asset size weighted. Some hedge fund indices give equal weighting to small hedge funds and large hedge funds, and others asset weight hedge funds, where large hedge funds dominate the performance. Since small and medium sized hedge funds have outperformed their larger peers over time, equally weighted hedge fund indices have performed better over time than asset weighted indices.. For example, in 2013 the asset weighted Bloomberg Hedge Fund Aggregate Index was up only 7.4% while the equally weighted Barclay Hedge Fund Index was up 11.1%. Asset-weighted indices are a better indication of how the total hedge fund industry assets have performed.
2. Liquid versus illiquid indices. Liquid hedge fund indices have both advantages and disadvantages versus traditional indices. These indices are more concentrated and try to replicate the performance of the hedge fund industry through separate accounts managed on their platform. These separate accounts omit less liquid securities which some would argue have greater return potential. In addition, many of the top managers will not accept mandates from these platforms, although over time they are becoming more accepted. The advantage of these indices are that they offer greater liquidity, are investable and reduce the probability of fraud.
3. Performance of sub-indices. In addition to the difference mentioned above there are also major differences in how indices classify hedge fund strategies. For example, there are very divergent definitions of what is an event driven strategy or relative value hedge fund strategy. This creates very large difference in performance within a strategy across various hedge fund indices.
In summary, hedge funds can provide many positive attributes to a multi-asset class portfolio. This includes low correlation with long only benchmarks, enhancement of downside protection, better risk adjusted returns, and most importantly for institutional investors, enhancement of forward looking returns to better match their actuarial rate of return. The S&P 500 is an inappropriate benchmark for hedge funds where the comparative monthly performance is almost meaningless. The media should use a 60% blend of the MSCI All Country World equity Index and 40% of the Barcap Global Aggregate Bond Index to better evaluate how the industry is doing.