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Hedge Funds: Diversification at Any Price? January 2018 Marketing material for professional investors or advisers only Hedge funds: Diversification at any price? January 2018 One of the key drivers of the mass adoption of hedge funds Johanna Kyrklund, CFA Global Head of Multi-Asset was that they provided a source of uncorrelated returns. With Investments asset class valuations increasingly stretched, this need to diversify risk has remained as pressing as ever, but the net of fee results from hedge funds in general have been mixed. In this context, our view is that multi-asset portfolios may provide a cheaper and simpler way of seeking risk-adjusted returns, leaving risk and fee budget for those hedge fund strategies which may genuinely offer uncorrelated returns. Whither diversification? Figure 1: Valuations across asset classes We all know the big picture; after eight years of good % returns and rates pinned close to 0%, valuations are 30 stretched across asset classes. The prospective returns on 25 government bonds, given starting yields, are particularly Earnings yield Bond yield concerning, especially since bonds have performed a dual 20 role in our portfolios, providing return and diversification. 15 Indeed, correlation between global equities and bonds has been historically low, even negative when currency 10 effects are excluded. A pick-up in inflation and possible 5 normalising of interest rates may lead to a less appealing correlation environment going forward and yields at 0 current levels may mean that the risk for bond markets is -5 skewed to the downside. As a result, many investors could be forgiven for being concerned that they may have seen the last of the “sweet spot” of declining yields and low US equities EU equities U equities EM equities correlation between equities and bonds. US 10y bond grade spread Japan equities US investment- German 10y bond Given this backdrop, while it would be foolish for investors EM debt local yield to shun bond markets altogether, it makes sense for US high-yield spread them to look to other sources of diversification and, for 20 year max 20 year min Current valuation many, the answer has been hedge funds. Clearly this Source: Bloomberg, Schroders, monthly data for the period ending 31 August 2017. strategy is not new and several types of investors have Valuation measured as the earnings yield for equities, the nominal yield for developed been utilizing hedge funds for many years in the search market and emerging market sovereign bonds and the spread for credit. for diversifying return streams. At this crucial juncture for investors considering how best to diversify, we provide Figure 2: Rolling three-year correlations between an analysis of potential consequences of the changing equities and bonds (local currency terms) dynamics of the hedge fund industry, as well as the return and risk characteristics of hedge funds in the context of 0.8 portfolio diversification. 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 1988 1993 1998 2003 2008 2013 Source: Citi, Datastream and MSCI, as at 31 July 2017. 1 When comparing strategies across asset classes, we also like Hedge fund industry dynamics – the times they to use a framework which breaks investment approaches are a changin’… into their major contributing risk factors, providing an One consequence of the increased focus of investors on the assessment in both absolute and relative terms as to what’s use of hedge funds within portfolios has been a change in driving these strategies and what investors should look for the ownership profile of these strategies. Historically these and need to understand. The factors that we employ in this funds were the preserve of individuals who, presumably, framework are equity beta, bond beta, factor risk, alpha were motivated by the superior return-generating ability of 1 2 risk, leverage risk and complexity risk . Below we compare hedge fund managers. Early adopters on the institutional an illustrative risk loading of a 60% equity/40% bond (60/40) side included endowments and foundations, keen to portfolio with hedge funds; hedge funds have provided a provide diversification and additional returns to their source of uncorrelated returns through a combination of portfolios. More recently, however, defined benefit plans alpha, leverage and more exotic risk premia (e.g. convertible have been increasing allocations to hedge fund strategies, arbitrage), with a concomitant rise in complexity. The while endowment and foundation allocations have impact of complexity is hard to quantify, but it should not plateaued somewhat in recent years. be ignored in that it may lead to a loss of transparency and often comes hand in hand with higher fees. Interestingly, Figure 5: Hedge fund allocations of US pension plans, the decision by the California Public Employees’ Retirement endowments and foundations System in 2014 to divest its allocation to hedge funds was attributed to their cost and complexity.3 % 18 Figure 3: 60% equities / 40% bonds 16 14 Equity beta risk 12 10 Complexity risk Bond beta risk 8 6 4 2 0 Leverage risk Factor risk All plans 5 Billion All plans 5 Billion All 1 Billion Corporate State and local Endowments defined-benefit defined-benefit and foundations plans plans Alpha risk 2005 2011 2014 2016 Source: Schroders. For illustration only. Source: Greenwich Associates and The Future of the Money Management Industry: Figure 4: Hedge funds The Hedge Fund Industry: The Low-Rate Vortex (FMMI), as at April 2017. Equity beta risk Interestingly, there has been a marked change in the balance of ownership, with a shift from individuals to institutions, as shown by the following graph. Complexity risk Bond beta risk Figure 6: US hedge fund industry assets Billion 2,500 2,250 2,000 Leverage risk Factor risk 1,750 1,500 Alpha risk 1,250 Source: Schroders. For illustration only. 1,000 750 1 This is the risk associated with either creating market exposure greater than the 500 underlying value of the portfolio or creating gross exposure by going long and short different assets. This exposure is usually created via the use of derivatives. 250 The former creates a net long, potentially directional market exposure whilst the latter may rely on relationships such as estimated correlation being maintained 0 2002 2007 2012 2016 ‘out of sample’ for risk to be managed effectively. Institutions Individuals 2 Complexity risk might include counterparty credit risk and liquidity risk. In this sense, aspects of complexity risk are not necessarily independent from leverage risk as they are sometimes incorporated within portfolios as a result of employing Source: FMMI as per Figure 5. Hedge Fund Research and Securities and Exchange leverage. Complexity risk might also be described as encompassing exposure Commission, as at April 2017. to operational and reputational risk. The more a fund employs more ‘esoteric’ strategies the more complex it becomes in terms of its risk profile. 3 Source: Bloomberg, https://www.bloomberg.com/news/articles/2014-09-15/ calpersto-exit-hedge-funds-citing-expenses-complexity. 2 Given the shift in ownership structure, it is interesting Figure 8: Global institutional investors’ return and to examine the expectations that investors have and volatility targets for hedge fund portfolios the reasons for their allocations to hedge funds. The % chart below shows the results of a survey of institutional 9 investors as to the factors determining their allocations to 8 hedge funds. 7 6 Figure 7: Global institutional investors: reasons for 5 investing in hedge funds, 2016 4 % 3 40 2 35 1 0 30 2014 2015 2016 2017 Memo: corporate bonds 25 volatility 1976 – 2016 20 Return Volatility 15 Source: Deutsche Bank Alternative Investor Survey and FMMI as per Figure 5, as at April 2017. 10 5 Given the expectations outlined above, we examined historical return characteristics of hedge funds over 0 long-term and recent time periods. We used the HFRI Uncorrelated Portfolio Superior Market-beating returns diversification risk-adjusted performance fund-weighted composite. We recognize that there is no returns perfect choice of index to measure the performance of hedge funds and each has its own set of characteristics. Source: Ernst & Young Global Hedge Fund and Investor Survey and FMMI as per Figure 5, as at April 2017. The HFRI index is widely used, however, and is a popular measure for studies of this kind. The chart below shows The overriding motivation for an investment in hedge hedge fund returns over rolling three-year periods. funds, in this survey at least, is a requirement for uncorrelated returns and portfolio diversification. Risk- Figure 9: Rolling three-year hedge fund returns adjusted returns and market-beating performance are (annualised*, USD terms) cited as essentially secondary concerns. This combination % of requirements is probably fine as long as returns stand up, but as more institutional performance and 30 risk comparisons become the norm it might be that 25 performance-related considerations come more to the 20 fore if hedge funds disappoint. 15 This survey suggests that, at least in the US, rate of 10 return and funding issues were institutional investors’ top concerns for 20164 and we believe that is likely to continue 5 to be the case going forward. If that is so, it is interesting 0 to note that a recent survey of institutional investors, -5 ranging from pension funds to family offices, revealed the 1994 1997 2000 2003 2006 2009 2012 2017 expectations for their hedge funds in terms of expected return and volatility outlined in Figure 8. *Average monthly returns annualised by multiplying by twelve. Source: Hedge Fund Research, Datastream, Schroders, as at 31 July 2017. These aggregate expectations, although they vary among different types of investor, are fairly ambitious given that During the early period covered by the graph, hedge they target equity-like growth (at a time when prospective fund returns were relatively healthy, showing positive, returns may be challenged) with bond-like volatility.
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