Chart of the Week

September 20, 2017

Justin Lenarcic , Global Alternative Investment Strategist

As Cycle Ages, Active Strategies May Be a Comeback Kid

Sources: Hedge Fund Research, Inc., Bloomberg, Wells Fargo Investment Institute, 9/17. Data from January 1992 through July 2017. This chart is for illustrative purposes only. It shows the historical performance trends between active investing in hedge funds as represented by the HFRI Fund Weighted Composite Index and passively investing in an index fund as represented by the S&P 500. Performance is calculated by taking the rolling two year return of the HFRI Fund Weighted Composite Index minus the rolling two year return of the S&P 500 Index. Gray bars represent recessions as defined by the National Bureau of Economic Research (NBER). The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions. Index returns reflect general market results, do not reflect actual portfolio returns or the experience of any investor, nor do they reflect the impact of any fees, expenses or taxes applicable to an actual investment. Unlike most asset class indices, HFR Index returns reflect deduction for fees and expenses. Because the HFR indices are calculated based on information that is voluntarily provided actual returns may be higher or lower than those reported. Past performance is not a guarantee of future results. Please see the end of the report for the description of the risks associated with these asset classes and for the definitions of the indices.

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The Cyclicality of Active and Passive Investing

It is important to consider that there is cyclicality for active investing. The most essential requirement for active management is the ability to distinguish between fundamentally strong and weak companies (and their securities), and for positive returns to be generated from taking long and short positions in those companies. Differences in capital structures, revenue, margins, and growth trajectories, for example, become more apparent later in the cycle, when both interest rates and inflation historically have risen. This is a key reason why active strategies have historically outperformed passive strategies leading up to, and during, recessions (Chart 1).

What it May Mean for Investors

In our opinion, framing the diversification debate as either active or passive falls short of truly understanding how the two approaches interact with each other. Instead, we believe, the decision should be around what percentage of a portfolio should be active relative to passive, given where we are in the market cycle. One can certainly acknowledge that the recent market environment has been more conducive to passive strategies than active management, but the critical question is whether that scenario is sustainable as the cycle matures and whether diversifying with alternative investment strategies such as those employed by hedge funds potentially become more valuable for a portfolio going forward.

Risk Considerations

All investing involves risk including the possible loss of principal. Different investments offer different levels of potential return and market risk. You should be aware of, and understand, all risks associated with a particular investment. Bear in mind that a diversified portfolio does not guarantee a profit or protect against loss including in a declining market.

Alternative Investments, such as hedge funds, are not suitable for all investors. They are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. While investors may potentially benefit from the ability of hedge funds to potentially improve the risk-reward profiles of their portfolios, the investments themselves can carry significant risks. Hedge funds trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods which can result in adverse consequences for the investor and the fund. There is no guarantee any hedging strategy will be successful or not incur loss.

Definitions

An index is unmanaged and not available for direct investment.

HFRI Fund Weighted Composite Index. A global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. Dollars and have a minimum of $50 Million under management or a 12-month track record of active performance. The HFRI Fund Weighted Index does not include Funds of Hedge Funds.

S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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