Global Investment Strategy

Weekly market insights and possible impacts on investors from the Wells Fargo Investment Institute Global Investment Strategy team.

November 28, 2016

Justin Lenarcic, Global Alternative Investment Strategist

Hedge Funds—Three Charts that May Change Perceptions

  • Hedge fund performance has been better than expected considering the recent interest-rate environment and lower beta of many hedge funds.
  • Quantitative easing may have contributed to one of the most challenging periods in history for active managers.
  • The historical relationship between global equity and global fixed-income correlations appears to be changing.

What it may mean for investors

  • We believe comparing absolute returns to long-only benchmarks overlooks why hedge funds are called “hedge” funds.

Hedge funds have faced heightened criticism of late. To be fair, there are reasons for investors to be disappointed. Broadly speaking, performance has been uninspiring, and the benefit of diversification has been overlooked amidst the second longest equity bull market in history. Dissatisfaction with performance (albeit over a rather unorthodox period for global assets and volatility), coupled with frustration over fees, has led some investors to “vote with their feet.” While we share in the frustration, we also believe that investors should not base their perception of hedge funds solely upon the relative return to long-only assets, especially without taking into consideration the past, and more importantly, the future environment. In this report, we discuss this topic and share three charts that shed light on, and may lead to reconsideration of, hedge funds.1

Past Performance may Actually Be Better than What Investors Think

Disappointing performance seems to be the most consistent complaint that investors direct at hedge funds, and the biggest hurdle to allocation decisions toward this asset class. But did hedge funds truly fall short of their expected return, or were expectations from investors too high given the changing market environment?

One of the tools investors use to estimate the relationship between risk and expected return is the Capital Asset Pricing Model (“CAPM”). CAPM is based on the theory that investors demand higher returns for higher risks. The tool uses three variables to calculate expected return: the risk-free rate of return (defined as the interest rate on a three-month U.S. Treasury bill), the expected return from the market, and the volatility of the security or portfolio relative to the market, also referred to as beta.2 The expected return of the market should be considered together with the risk-free rate, and importantly, the beta.3 As the risk-free rate declines, so should expected returns. Ten years ago, the risk-free rate was 4.5 percent. Today, it is 0.49 percent.4 Given such a large drop in the risk-free rate, we believe it is reasonable to adjust expected returns lower.

Chart 1 shows the difference between actual hedge fund performance as represented by the HFRI Fund Weighted Composite Index and its expected performance using the 12-month rolling risk free rate, 12-month rolling beta of the HFRI Fund Weighted Composite Index to the MSCI World Index, and 12-month rolling return of the MSCI World Index.5 In green shaded periods, actual hedge fund index performance exceeded the expected return, and in the periods shaded blue, hedge funds underperformed. There are periods when performance disappointed, such as late 2011 through 2012 and the first half of 2016. However, there also are periods, such as the middle of 2009 through the third quarter of 2011, when hedge funds outperformed their market beta, in some instances by a wide margin. The same occurred from the summer of 2014 through the summer of 2015, and this trend appears to be materializing again.

Chart 1. Hedge Fund Performance has Actually Been Better than Market Sensitivity (Beta) Would IndicateChart 1. Hedge Fund Performance has Actually Been Better than Market Sensitivity (Beta) Would IndicateSource: Bloomberg, 11/4/16. Chart is for illustrative and information purposes only and does not represent actual performance achieved by any investor. Actual returns of a hedge fund could be significantly higher or lower than forecasted. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

Beta-adjusted performance, more commonly referred to as “alpha,” is a metric that many investors use to quantify the performance of active investment management.6 The magnitude of alpha is important, but so is the persistency and stability of alpha. While some investors might think that hedge funds have failed to generate alpha over the past 10 years, we have found the opposite is true. Twelve-month rolling alpha has been positive nearly 63 percent of the time from September 2006 through September 2016.

Fixed Income May Not Reduce Downside Exposure Like It Has Historically

The traditional relationship between equities and fixed income appears to be changing. Historically, correlations between fixed income and equities have been low and, at times, even negative, with fixed income having provided investors with a valuable source of diversification and yield—not to mention a buffer against adverse moves in equities.7 Since the financial crisis, however, the correlation between global equities and global fixed income has increased, while average yields have decreased, diminishing the diversification benefit of fixed income (over this period). On the other hand, the Macro strategy, which attempts to capture long and short trends within global asset classes, has seen a decrease in the correlation to global equities, especially over the past 18 months, which could provide an alternate source of diversification and help lower downside exposure.

Chart 2. Global Equities and Fixed Income Correlations Have Been Trending HigherChart 2. Global Equities and Fixed Income Correlations Have Been Trending HigherSource: Bloomberg, 10/16. Global equities are represented by the MSCI World Index. Global fixed income is represented by the Bloomberg Barclays Global Aggregate Bond Index. The 220 Day Moving Average is used to illustrate a longer-term trend of the correlation. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment.

The Credit Cycle is Maturing

There are some worrisome undercurrents within the corporate credit market that bear watching. Even putting aside the troubled Energy sector, leverage is approaching the cyclical peak, while the coverage ratio has deteriorated.8 The default rate, again ex-energy, is edging higher while underwriting standards continue to weaken. These conditions historically have been present prior to recessions and should give investors pause when reaching for yield in a low-rate environment. This is not to say that corporate credit is on the brink of collapse or that recession is imminent, but rather, it serves as a reminder to investors that hedge funds, especially those that focus on credit such as Relative Value and Event Driven, might actually be entering a better environment for active management than they had been exposed to after the 2008-2009 financial-crisis. At a minimum, investors should consider whether a long-only allocation to credit would be complemented by a less-directional, hedged allocation.

Chart 3. Even Ex-Energy—Leverage Ratios have been Increasing while Coverage Ratios have been DecreasingChart 3. Even Ex-Energy—Leverage Ratios have been Increasing while Coverage Ratios have been DecreasingSource: Bank of America Merrill Lynch, 10/16. RHS = right-hand scale, LHS = left-hand scale

Investment Implications

Many investors recognize that the post-crisis environment has been an unprecedented one for active managers. The collective balance sheet of global central banks should eventually deflate, which may reduce the support for risky assets that we have observed in recent years. The low-rate environment, on the other hand, appears to be normalizing, which could disrupt the long-term relationship between equities and fixed income. A maturing credit cycle, coupled with diminished liquidity, is a recipe for price volatility, and may affect value for investors that have flocked to the perceived safety of more liquid vehicles. Finally, when investors review performance for the last three, five, or even 10 years, they likely will see outperformance of long-only investments compared to hedge funds. Yet we believe that hedge fund performance should be measured on a beta-adjusted basis, taking into consideration the impact of a markedly lower risk-free rate and the goal of most hedge funds to minimize market sensitivity. Simply comparing absolute returns to long-only benchmarks overlooks why hedge funds are called “hedge” funds.

1 Hedge funds are only available to persons who are “accredited investors” or “qualified purchasers” within the meaning of U.S. securities laws. They are complex, speculative investment vehicles and are not suitable for all investors.
2 The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk and expected returns for assets. The CAPM model says that the expected return of a security or portfolio equals the rate on a risk-free security plus a risk premium. CAPM has certain limitations and should not be used in isolation.
3 Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
4 Source: Bloomberg, yield as of November 24, 2016.
5 Expected hedge fund performance is calculated using the CAPM methodology discussed above. The risk-free rate is represented by the three-month U.S. Treasury bill; Beta is between the MSCI World Index and the HFRI Fund Weighted Composite Index, the Market return is performance of the MSCI World Index. This calculation assumes no alpha is being generated.
6 Alpha is the rate of return on a security or portfolio in excess of what would be predicted by the Capital Asset Pricing Model (CAPM).
7 Correlation is a statistic that measures the degree to which two securities more in relation to each other. It does not measure the magnitude of that movement. There is no guarantee that future correlations between asset classes will remain the same.
8 The leverage ratio examines how much capital comes in the form of debt (loans), or assesses the ability of a company to meet financial obligations. In this instance, the leverage ratio reflects total debt / total equity. The coverage ratio is a measure of a company’s ability to meet its financial obligations. Source: Bank of America Merrill Lynch, 10/16.

Risk Factors

Hedge funds are an alternative investment vehicle not suitable for all investors. Any offer to purchase or sell a specific hedge fund will be made by the product’s official offering documents. Investors could lose all or a substantial amount investing in hedge funds. They are open to qualified investors only and carry high costs, substantial risks, and may be highly volatile. There is often limited (or even non-existent) liquidity and a lack of transparency regarding the underlying assets. They do not represent a complete investment program. There is no secondary market for the investor’s interest in a hedge fund and there is no guarantee one will develop. In addition, there may be restrictions on transferring interests in a hedge fund.

Hedge fund strategies employ aggressive investment techniques, including using short sales, leverage, swaps, futures contracts, options, forward contracts and other derivatives which can expose the investor to substantial risk. The use of short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the investment. In addition, taking short positions in securities is a form of leverage which may cause a portfolio to be more volatile. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks which may hurt a fund’s performance. Counterparty risk is the risk that the other party to the agreement will default at some time during the life of the contract. The use of derivatives for other than hedging purposes is considered speculative and involves greater risks than those associated with hedging. Investing in derivatives carries the risk of the underlying instrument as well as the derivative itself and may not be successful, resulting in losses to the fund, and the cost of such strategies may also reduce the fund’s returns. Purchasing and writing options are highly specialized activities and entail greater than ordinary investment risks. The successful use of options depends in part on the ability of the manger to manage future price fluctuations and the degree of correlation between the options and securities markets. No assurance can be given that such judgments will be correct. Options are subject to sudden price movements and are highly leveraged, in that payment of a relatively small purchase price, called a premium, gives the buyer the right to acquire an underlying security interest that may have a face value greater than the premium paid.

Definitions

An index is unmanaged and not available for direct investment.

Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. It is comprised of the U.S. Aggregate, Pan-European Aggregate, and the Asian-Pacific Aggregate Indexes. It also includes a wide range of standard and customized subindices by liquidity constraint, sector, quality and maturity.

The HFRI Fund Weighted Composite Index is 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 Composite Index does not include Funds of Hedge Funds.

The MSCI World Index is a free float‐adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The index consists of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

Global Investment Strategy is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by the Global Investment Strategy division of WFII. 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.

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.

Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC (WFCS) and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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