Is There Still Diversification in Hedge Funds? the COVID-19 Pandemic Has Swept the Globe Leaving No Asset Class Unaffected

is there still diversification in hedge funds? The COVID-19 pandemic has swept the globe leaving no asset class unaffected. Dispersion across hedge funds has been pronounced, so while the paper used data prior to the recent market turmoil, the philosophical tenets of fund selection and portfolio construction remain pertinent and are reinforced by current market conditions.

While public markets (e.g. equities and bonds) remain a cornerstone of investment portfolios, investors have long sought to diversify beyond these exposures. Hedge funds have been one means of diversifying and accessing alternative return drivers. There is a wide range of investment strategies within the hedge fund universe resulting in significant dispersion of investment performance. Nonetheless, analysis of historical return patterns can provide some insight into the potential benefits of hedge funds and their uses.

This paper reviews the characteristics of a broad universe of hedge funds, hedge fund subcategories, return patterns, and some considerations for portfolio construction.

Indices typically seek to combine underlying positions with commonalities; however, this is not the case for hedge funds, as the universei includes a wide swath of actively managed investment strategies. These strategies can be divided into four categories: equity hedgeii, event driveniii, macroiv, and relative valuev.

• Equity hedge represents the largest category by number of funds (figure 1) and most equity sensitive (figure 4). These strategies target opportunities within equities and may go long or short, so while investments are similar to traditional equity, funds have greater flexibility to express an investment thesis and mitigate market risk. • Event driven generates returns surrounding corporate transactions, using a variety of financial instruments. By emphasizing individual transactions, funds are able to reduce typical market (i.e., beta) risk. • Macro uses a variety of financial instruments to generate returns, but rather than targeting company specific events, these funds use financial instruments to reflect an economic view. Fund views may be optimistic or pessimistic on asset classes and currencies, and the portfolio can shift dramatically. Often, macro funds exhibit very little consistent market sensitivity (figure 3). • Relative value emphasizes convergence of price between two or more financial instruments, utilizing a multitude of securities. While similar to event driven strategies, funds have a wider range of potential catalysts to exploit.

However, even within these broad categories, the latitude afforded to hedge fund managers results in a highly varied set of characteristics. This combined with peer group index construction creates challenges to drawing conclusions based on the index data.

Relative value 21%

Equity hedge 48% Macro 19%

Event driven 13%

Source: Hedge Fund Research, HFR Global Hedge Fund Industry Report – Year End 2019

The hedge fund “industry” has a formally accepted inception year of 1990, as does the Hedge Fund Research Index. Importantly, institutional interest has increased over the years, with the industry evolving and expanding to assets of nearly $3.3 trillion today and approximately 8,000 individual offerings as shown in figure 2. To date, most underlying managers and resulting exposures have been based in developed markets with the large majority in the U.S. and Europe. As global markets and the hedge fund industry continues to evolve, the number of available options has increased, requiring a greater focus on manager selection.

9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 - 1991 2011 1997 1993 2017 1992 1999 2013 1995 1996 1998 1994 2012 2019 1990 2015 2016 2018 2014 2001 2010 2007 2003 2002 2009 2005 2006 2008 2004 2000

Source: Hedge Fund Research, HFR Global Hedge Fund Industry Report – Year End 2019

Figure 3 Estimated number of funds launched/liquidated

2,500 2,000 1,500 1,000 500 - (500) (1,000) (1,500) (2,000) 2011 1997 2017 1999 2013 1996 1998 2012 2015 2016 2018 2014 2001 2010 2007 2003 2002 2009 2005 2006 2008 2004 2000

Source: Hedge Fund Research, HFR Global Hedge Fund Industry Report – Year End 2019

5 © 2020 Mercer LLC. All rights reserved. Even in light of these imperfections, historical returns can help investors test how the universe has evolved and estimate the sensitivities of each strategy. Since a key goal of hedge funds is to diversify away from common risk factors like equities, it is important to measure how influenced the broad universe has been. Figure 4 illustrates this relationship on a rolling three-year basis. Each strategy bears some sensitivity to equity market moves, as even strategies relying on idiosyncratic risks may be affected by large market swings.

As expected, equity hedge strategies consistently exhibit the highest sensitivity to the equity market. Macro exhibits the greatest variation and generally lowest sensitivity to equity markets. Event driven and relative value strategies are somewhere in between. With all strategies exhibiting betas below one, investors should expect reduced upside and downside participation from hedge funds broadly (figure 5 & table 1). It is in the up and down market capture that one begins to see the effect of the increasing number of funds in the index. Since the index equally weights each fund, increases in the number of funds dilutes the contribution of each fund’s idiosyncratic exposures (i.e., fund specific), and unfortunately, the asymmetric distribution between up and down capture has converged at the index level, approaching the beta.

Figure 4 Rolling 36-Month Beta With MSCI ACWI Rolling 36-month beta with MSCI ACWI

0.70.7

0.60.6

0.50.5

0.40.4

0.30.3 Index Beta to ACWI Index beta to ACWI beta to Index 0.20.2

0.10.1

0.00.0 Dec-1 1 Dec-1 7 Dec-1 3 Dec-1 2 Dec-1 5 Dec-1 9 Dec-01 Dec-1 0 Dec-1 4 Dec-1 6 Dec-1 8 Dec-97 Dec-93 Dec-92 Dec-99 Dec-07 Dec-95 Dec-96 Dec-03 Dec-94 Dec-98 Dec-02 Dec-09 Dec-05 Dec-06 Dec-00 Dec-04 Dec-08 Dec-11 Dec-17 Dec-13 Dec-12 Dec-19 Dec-15 Dec-16 Dec-18 Dec-14 Dec-10 Dec-01 Dec-97 Dec-93 Dec-07 Dec-92 Dec-99 Dec-03 Dec-95 Dec-96 Dec-98 Dec-94 Dec-02 Dec-09 Dec-05 Dec-06 Dec-08 Dec-04 Dec-00 Period Ended Period Ended

HFRI fund weighted hedge fund HFRI macro HFRI Fund Weighted Hedge Fund HFRI Equity Hedge HFRI Event Driven HFRI equity hedge HFRI relative value HFRI Macro HFRI event driven HFRI Relative Value

Source: MSCI, Hedge Fund Research, FTSE, & Mercer Calculations Beta estimated using monthly returns in excess of the risk-free rate, FTSE 3-month T-Bills as of end of 2019. Please see Appendix for Index definitions. Copyright 2019 Mercer LLC. All rights reserved. FileNameGoesHere > Insert > Header and Footer > to change 1

0%0%

-20%-20% Percent of MSCI ACWI

Percent of MSCI ACWI Percent -40%-40%

-60%-60%

-80%-80% Dec-1 1 Dec-1 3 Dec-1 7 Dec-1 2 Dec-1 5 Dec-1 9 Dec-1 4 Dec-1 6 Dec-1 8 Dec-01 Dec-1 0 Dec-97 Dec-93 Dec-92 Dec-07 Dec-95 Dec-99 Dec-03 Dec-94 Dec-96 Dec-98 Dec-02 Dec-05 Dec-09 Dec-00 Dec-04 Dec-06 Dec-08 Dec-11 Dec-17 Dec-13 Dec-12 Dec-19 Dec-15 Dec-16 Dec-18 Dec-14 Dec-10 Dec-01 Dec-97 Dec-93 Dec-07 Dec-92 Dec-99 Dec-03 Dec-95 Dec-96 Dec-98 Dec-94 Dec-02 Dec-09 Dec-05 Dec-06 Dec-08 Dec-04 Dec-00 Period Ended Period Ended

Up C ap ture Down Capture Up capture Down capture

Source: MSCI, Hedge Fund Research, & Mercer Calculations Capture is estimate as the average monthly hedge fund index return when the MSCI AWCI generates positive (up capture) and negative (down capture) returns relative to the average monthly MSCI ACWI return in each category. Past performance is no guarantee of future results.

MSCI ACWI capture Index Up Down HFRI fund weighted hedge fund 36% 32% HFRI equity hedge 50% 51% HFRI event driven 36% 32% HFRI macro 9% 3% HFRI relative value 28% 17%

Source: MSCI, Hedge Fund Research, & Mercer Calculations Capture is estimate as the average monthly hedge fund index return when the MSCI AWCI generates positive (up capture) and negative (down capture) returns relative to the average monthly MSCI ACWI return in each category (60-months ended 9/30/2019) - Past performance is no guarantee of future results. Please see Appendix for Index definitions.

7 © 2020 Mercer LLC. All rights reserved. At the index level, the dilution of individual idiosyncratic exposures helps reduce the overall volatility of the index, which amplifies correlations to public factors even when the individual fund sensitivities are low. So while the broad index and sub-indices all exhibited equity betas below one, correlations to public equity have risen over time, excluding macro (figure 6). Similar to the beta analysis, the macro index has continually represented diversification to public equity risks, benefiting not only from the strategy but also the variety of underlying fund strategies. The index data are fraught with interpretation problems, so to further evaluate the diversification benefits of hedge funds it is important to dive a bit deeper.

Figure 6 Rolling 36-monthRolling correlation 36-Month with Correlation MSCI ACWI With MSCI ACWI

1.01.0

0.90.9 0.80.8 0.70.7 0.60.6 0.50.5 0.40.4 0.30.3 0.20.2 Index Correlation With ACWI

Index correlation with ACWI correlation Index 0.10.1 0.00.0 Dec-1 1 Dec-1 7 Dec-1 3 Dec-1 2 Dec-1 9 Dec-1 5 Dec-1 6 Dec-01 Dec-1 0 Dec-1 4 Dec-1 8 Dec-97 Dec-93 Dec-92 Dec-99 Dec-07 Dec-95 Dec-96 Dec-03 Dec-94 Dec-98 Dec-02 Dec-09 Dec-05 Dec-06 Dec-00 Dec-04 Dec-08 Dec-11 Dec-17 Dec-13 Dec-12 Dec-19 Dec-15 Dec-16 Dec-18 Dec-14 Dec-10 Dec-01 Dec-97 Dec-93 Dec-07 Dec-92 Dec-99 Dec-03 Dec-95 Dec-96 Dec-98 Dec-94 Dec-02 Dec-09 Dec-05 Dec-06 Dec-08 Dec-04 Dec-00

PeriodPeriod Ended Ended

HFRI fund weighted hedge fund HFRI macro HFRI Fund Weighted HedgeHFRI equityFund hedgeHFRI Equity Hedge HFRI EventHFRI Driven relative value

HFRI Macro HFRI event drivenHFRI Relative Value

Source: MSCI, Hedge Fund Research & Mercer Calculations. Please see Appendix for Index definitions.

While diversification at the index level is less visible, the underlying universe of funds remains quite disparate, which is reflected in the constituents’ equity sensitivities (figure 7). The medians (50th percentiles) are in line with the broader index but the distributions are wide. This is the case even between the 25th and 75th percentiles, where beta ranges from 0.3 to 0.8 for equity hedge strategies and -0.1 to 0.2 for macro strategies. The range of manager sensitivities highlights the importance of manager selection for the creation of an appropriate diversifying basket that achieves the desired objectives.

This dispersion in manager beta also extends to correlation, but unlike beta, there is a significant difference between the average fund and the index’s correlation to the MSCI All Country World Index (ACWI) (figure 8), as idiosyncratic fund exposures are not offset. A similar effect is displayed in the comparison of the indices’ standard deviations (figure 9) where the indices experience a much lower volatility. Finally, correlations between funds remain relatively low (figure 10), suggesting significant dispersion in return drivers even within each category

Figure 7 Distribution of funds’ trailing 60-month beta to MSCI ACWI

1.4 1.2 1.0 0.8 0.6 0.4

Beta to ACWI Beta to 0.2 0.0 -0.2 -0.4 HFRI HFRI HFRI HFRI HFRI fund weighted equity hedge event driven macro relative value index

Percentiles 5th-25th 25th-75th 75th-95th 50th Index

Source: MSCI, Hedge Fund Research, FTSE, & Mercer Calculations (60-months ended 9/30/2019) Beta estimated using monthly returns in excess of the risk-free rate, FTSE 3-month T-Bills. Please see Appendix for Index definitions.

1.00 0.80 0.60 0.40 0.20 0.00 -0.20 Correlation to MSCI ACWI to Correlation -0.40 HFRI HFRI HFRI HFRI HFRI fund weighted equity hedge event driven macro relative value index

Percentiles 5th-25th 25th-75th 75th-95th 50th Index

Source: MSCI, Hedge Fund Research, & Mercer Calculations (60-months ended 9/30/2019)

Figure 9 Distribution of funds’ trailing 60-month standard deviation

30%

25%

20%

15%

10%

Annualized Standard Deviation Standard Annualized 0% HFRI HFRI HFRI HFRI HFRI fund weighted equity hedge event driven macro relative value index

Percentiles 5th-25th 25th-75th 75th-95th 50th Index

Source: Hedge Fund Research & Mercer Calculations (60-months ended 9/30/2019).

Please see Appendix for Index definitions.

0.30

0.25

0.20

0.15

0.10

0.05

0.00 HFRI HFRI HFRI HFRI HFRI fund weighted equity hedge event driven macro relative value index

Source: Hedge Fund Research & Mercer Calculations (60-months ended 9/30/2019). Please see Appendix for Index definitions.

The nature of unconstrained mandates combined with wide investment opportunity sets results in a hedge fund universe with a wide variety of strategies. This enables investors to design custom portfolios to achieve any number of risk and return profiles. In our view, the optimal use case is one that complements traditional public market exposures so as to diversify risks.

The multitude of underlying characteristics investors can access, however, increases the level of due diligence for fund selection and portfolio construction. Because hedge funds possess significant manager specific risk (i.e., disparate styles, portfolio and risk management along with small business risk), investors should carefully select and size positions within portfolios. As outlined above, over diversification results in disappointing index-like results with the fund specific risks diluted.

The net result of over diversification is increased correlation to public market exposures with downside protection, but too much give up on the upside. So, the goal of portfolio construction is to efficiently harvest unique risk while not excessively exposing the portfolio to a single fund’s ability to execute (figure 11 & 12) and controlling for over diversification. The nature of each underlying fund will dictate overall sizing and the number of funds in the diversifying portfolio, but a hypothetical example in figure 12 demonstrates how increasing the number of funds can help manage and theoretically smooth the extraction of fund specific returns.

Figure 11 Decomposing risk drivers

100% 60/40 portfolio risks 80% Unique risk (unexplained variance) 60%

40%

20%

0% HFRI Average fund fund weighted index

Source: MSCI, Bloomberg, Hedge Fund Research, & Mercer Calculations Explanatory power represents the r-squared (percent of variance) of the index and average fund regressed against a 60% MCSI ACWI and 40% Bloomberg Aggregate portfolio over trailing 60-months ended 9/30/2019

100% 1.00 90% 9.0 Correlation to 60/40 portfolio

80% 8.0 70% 7.0 60% 6.0 50% 5.0 40% 4.0

portfolio of variance portfolio 30% 3.0 Unique risk as a percent - Unique risk as a percent 20% 2.0 10% 1.0 0% 0.0 Increasing number of hedge funds in portfolio (equally weighted)

Index correlation to 60/40 portfolio (rhs) Hedge fund portfolio correlation to 60/40 portfolio (rhs) Hedge fund portfolio unique risk (unexplained variance)

Source: MSCI, Bloomberg, Hedge Fund Research, & Mercer Calculations The hedge fund portfolio represents the combination of hypothetical average funds together, assuming each fund expresses the average correlation to other funds and an equal standard deviation. For illustrative purposes only. Unique explanatory power represents the 1 minus the r-squared (percent of variance) of the index and hedge fund portfolio regressed against a 60% MCSI ACWI and 40% Bloomberg Aggregate portfolio over trailing 60-months ended 9/30/2019

The universe of hedge funds has changed dramatically over the last thirty years. This includes significant growth in the number of funds, strategies, and assets under management, as well as fund closures. While indices suggest the level of diversification has diminished, they do not represent an accurate illustration of what tailored manager selection and portfolio construction can achieve.

Even though the rational for allocating to hedge funds can vary across investors, generally investors desire investments that deliver certain return characteristics that cannot be accessed easily through traditional vehicles. These strategies seek to deliver returns based on idiosyncratic drivers, rather than reliance on broad market factors, which means the strategies involve a high level of active management and expert knowledge. Selection of hedge funds requires extensive due diligence to evaluate the managers’ ability to deliver return outcomes, as they often rely on the use of esoteric and complex securities.

Creating a portfolio of hedge funds is even more challenging. As an evaluation of the indices indicate, over diversification can diminish the benefits of a hedge fund allocation. This may lead investors to question the allocation at times. It is important for investors to define clearly the objectives and constraints in defining the role a hedge fund allocation is expected to serve within a broader portfolio. A carefully designed portfolio should contribute the desired sensitivity to public market allocations, while providing access to unique return drivers not accessible through traditional, long only strategies, thereby enhancing overall investment program construction.

Manager observations Count HFRI fund weighted index 1012 HFRI equity hedge 519 HFRI event driven 118 HFRI macro 171 HFRI relative value 204

iThe HFRI Fund Weighted Index will serve as a proxy for the direct hedge fund universe.

iiHedge Fund Research Description: Equity Hedge, Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.

iiiHedge Fund Research Description: Event-Driven, Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

ivHedge Fund Research Description: Macro, Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.

15 © 2020 Mercer LLC. All rights reserved. vHedge Fund Research Description: Relative Value, Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

Certain Risk Factors • Any person implementing a direct hedge fund program must be able to bear the risks involved and must meet each fund’s suitability requirements. Direct hedge fund programs may not be suitable for certain investors. • No assurance can be given that the investment objective will be achieved. Among the risks which prospective investors should note are the following: - An investment in a hedge fund is speculative and involves a high degree of risk. - Implemented hedge fund programs will focus to some extent on less liquid hedge funds. Implementation is, therefore, suitable only for those persons who have a limited need for liquidity in their investment. - Performance may be volatile. - Implemented hedge fund programs involve allocating capital to Portfolio Managers. - Hedge funds may invest globally, including in countries where disclosure and legal systems are underdeveloped, accounting standards are uncertain and where there is continual risk of government intervention, expropriation and/or confiscatory taxation. - Hedge funds may use a substantial degree of leverage, causing the performance results of the program to be correspondingly volatile. - There is generally no secondary market for the constituent fund shares. - Investors are advised to consult their own counsel with respect to the legal and tax implications of an investment in the Shares. - The constituent fund shares are generally not transferable. - Implementing a direct hedge fund program could be subject to certain conflicts of interest.

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May 2020