Helpful Hedge Funds?

In last October’s blog Alternative Asset Allocation: Tricks and Treats I looked at how the expected return and risk of a portfolio could be improved by adding alternative assets such as private equity and private debt. This month I investigate whether including hedge funds in the asset mix helps a portfolio.

Friendly Facts

Let’s start with the main attributes of hedge funds (for more details see Investopedia):

• They are financial partnerships that use pooled funds and different strategies to earn active returns
• They may be managed aggressively and use derivatives and leverage to generate higher returns
• Strategies include long-short credit and equity, macro, volatility arbitrage, and merger arbitrage
• They typically expect to make money whether the markets are going up or down through hedging market risk or reducing exposure to markets by going short
• They are generally only accessible to accredited investors

And I will add:

• They charge big fees, with the standard structure 1.5% to 2% of assets under management plus a performance fee of 15-20% of the returns above a certain hurdle rate of return
• Although they are called hedge funds, they typically have not hedged out all market exposure

Considerate Categories

The three categories of hedge funds I looked at utilized credit, equity hedge, and macro strategies. The data source is HFRI, which also provides the descriptions for each HFRI index:

Credit Index

• A composite index of strategies trading primarily in credit markets

Equity Hedge (Total) Index

• Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. Managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.

Macro (Total) Index

• Investment Managers who 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.

Neighbourly Numbers

Chart 1 shows the actual returns (in Canadian dollars) and risk (standard deviation of returns) for various asset classes for the ten years ended March 2022[1]. The traditional public market asset classes (Canadian T-bills, Canadian bonds, Canadian stocks, U.S. stocks, and international stocks) are shown in blue. The alternative asset classes (private debt, infrastructure equity, real estate equity, secondary private equity, private equity, and venture capital) are shown in orange. The hedge funds (credit, equity hedge, and macro) are shown in yellow.

What stands out is that the hedge fund returns were much lower than the alternative fund returns. For example, credit hedge funds returned much less than private debt with only a slightly lower risk (standard deviation of return). Equity Hedge funds returned somewhat less than Canadian and international stocks, but only just over half the return of U.S. stocks, albeit at a much lower risk. Macro hedge funds generated the lowest returns of all the hedge funds and alternatives.

Chart 1

Given the different investing processes and mandates for hedge funds they are also less correlated to traditional assets, as seen in Table 1. A less risky portfolio (lower standard deviation of return) can be constructed by combining assets whose returns are not highly correlated. Higher correlations (each asset is 100% correlated with itself in the table) are indicated by increasing levels of green shading. Lower or negative correlations are shown by increasing levels of red shading. Macro hedge funds have among the lowest of the correlations to the other assets. Credit hedge funds have a very low correlation with Canadian stocks. Everything else being equal, adding hedge funds to a portfolio will lower its risk.

But of course, everything else is not equal as expected returns matter.

Table 1

Caring Cautions

Hedge funds have some of the same risks that were outlined for alternatives assets in Alternative Asset Allocation: Tricks and Treats. The main risks are shown in Table 2.

Table 2

Since most hedge funds utilize publicly traded securities, they don’t suffer from the same valuation issues that alternative assets do. This means that the returns for hedge fund indices don’t need to be desmoothed.

Supportive Scenarios

I can now perform a mean-variance optimization process, using the risk measures from Chart 1 and the correlations from Table 1. I also need expected return data, so I have provided conservative 10-year annualized return expectations in Table 3.

Table 3

Chart 2 below plots the expected return and risk for various optimized asset mixes with 40%, 50%, 60%, and 70% of assets in stocks, alternatives (except private debt) and hedge funds (except credit hedge funds) and the remainder in bonds, private debt, and credit hedge funds. The three curves represent those asset mixes under three scenarios. The first curve (orange) is each asset mix using only traditional assets (bonds and stocks). The second curve (blue) is adding 20% non-traditional assets (10% alternatives and 10% hedge funds). The third curve (green) adds 20% non-traditional assets only in alternatives.

Chart 2

Adding 20% non-traditional assets (10% alternatives and 10% hedge funds) boosted returns by 0.4% to 0.5% for all the asset mixes while keeping risk the same. However, adding 20% non-traditional assets, restricted to alternatives, boosted returns another 0.1% to 0.2%. What this means is that while hedge funds have lower correlations to traditional assets, alternatives do as well yet with higher expected returns. I used higher expected returns for alternatives versus hedge funds as this outcome has been fairly consistent when looking at the historical returns over different time periods.

Productive Portfolios

So are hedge funds helpful? Based on my assumptions of the expected returns and historical risks, adding hedge funds and alternative assets to the asset mix of traditional assets can help to increase the expected return of a portfolio for the same risk. While not shown in this blog, adding only hedge funds doesn’t significantly increase expected return at each level of risk, but they can lower risk for the same expected return. So the caveat is that I think adding alternative assets to the mix works even better, possibly to the extent of excluding hedge funds.

As always, the choice of investment manager for a fund is critical, especially for hedge funds and alternatives. For the analysis I used return indices, which consist of hundreds or thousands of funds. The performance of these investment managers can and do vary considerably around the indices’ returns.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.

[1] The most recent data available for alternative assets is March 2022. The data sources are S&P Global, BlackRock, Investing.com, FTSE Russell, MSCI, PitchBook, Preqin, and HFRI. The returns for the alternative assets have been desmoothed as outlined in Alternative Reality: Return and Risk