Alternative investments are still not fully destigmatised by many investors, despite the fact that their inclusion in balanced portfolios has proven their merit at least twice during the previous decade. The purpose of this series of reports is to demystify some of the misconceptions still surrounding alternative investments.
Equities outperform hedge funds over the long run
There is a Wall Street aphorism that says a bull market misleads the average investor to mistake themselves for a financial genius. This wisdom also applies to the recent period of reflation and central bank intervention, where the abundant liquidity lifted nearly all boats. The various stimuli of the past couple of years probably would even make Lance Armstrong blush. However, markets oscillate; bull markets start and eventually end. Or, as Herbert Stein (1916-1999), Chairman of the Council of Economic Advisers under Presidents Richard Nixon and Gerald Ford, put it: “If something cannot go on forever, it will stop.”
Which return sequence (see Table 1) do you prefer, portfolio A or B?
Portfolio A is represented by the S&P 500 Index with dividends reinvested, a proxy for the long-only equity market. The three returns are the five-year returns for the 15-year period from January 2000 to December 2014. Starting at 100 in January 2000, a -11% return brought the portfolio to 89 by December 2004. The subsequent 2% total return lifted portfolio A to 91 by December 2009. Adding a 105% return from a starting point of 91 brought the portfolio to 186 by the end of 2014. The annual growth rate from 100 to 186 over 15 years is 4.2%.
Portfolio B is represented by the HFRI Fund Weighted Composite Index, a proxy for the average, well-diversified hedge funds portfolio, net of one layer of fees. Starting at 100 in January 2000, a 42% return brought the portfolio to 142 by the end of 2004. 142 is arguably a big difference to the 89 in the long-only example. It is this big difference that put hedge funds on the agenda of many investors, institutional as well as private. The subsequent return of 32% lifted the portfolio from 142 to 187 by the end of 2009. The subsequent 5-year return of 25%, which was low by historical hedge funds standards, brought the portfolio to 234 by the end of 2014. The annual growth rate from 100 to 234 over 15 years is 5.8%.
The superior long-term performance of portfolio B stems from avoiding large losses and long periods of negative compounding. Portfolio B, therefore, is more “boring” as the returns do not swing around as much as with portfolio A. One of the many ironies of investment life is that regulators, large parts of Main Street, and an astonishingly large part of Wall Street think that portfolio B is riskier than portfolio A. It isn’t. It is less liquid, but not necessarily riskier. The returns are higher and the market risk is lower, nearly irrespective of how we calculate risk: Volatility of portfolio B is lower and drawdowns are much lower. We could argue that portfolio A represents “nature” while portfolio B is a return sequence that is “man-made.”
Table 2.1 and Table 2.2 shows how it’s done by avoiding large losses. The first returns are the monthly returns of the S&P 500 Index since 1990. We applied a color-coding whereby returns worse than -5% are highlighted in grey and returns lower than -10% are highlighted in black. It is these losses that destroy the rate at which capital compounds. We called this “nature” because all investors can obtain these returns passively with index funds or ETFs these days. No active risk-management skill is applied to the first sequence of returns. The second set of monthly returns in Table 2.2 is the (total) returns of the HFRI Fund Weighted Composite Index, our proxy for the average hedge funds portfolio net of fees. The same color-coding was applied. The second sequence is literally less colorful, i.e., more “boring.” This is, as George Soros put it, a good thing. These returns are “man-made” as they do not appear in “nature,” in financial markets. These returns need to be “fabricated.” The discipline that results in these man-made returns is active risk management. It cannot be done otherwise. A certain craft or skill needs to be applied to “nature,” – the erratic vagaries of financial markets. This is why sometimes the returns in Table 2.1 are referred to as “market-based returns” whereas the returns on the right are branded “skill-based returns.”
A further, but nontrivial aspect of the returns in Table 2.2 is that the men and women “fabricating” these returns often have their own money in their funds. This means they have a very simple, hands-on incentive to avoid the loss of capital – simple incentives are nearly always better than complicated, or “sophisticated” incentive structures. Mutual funds generally remunerate management based on a percentage of assets under management. Hedge funds always remunerate managers with performance-related incentive fees as well as a fixed fee. Not surprisingly, the incentive-based performance fees favors the “fabrication” of an asymmetric return profile; profits are welcome, losses are to be avoided at nearly all cost. As Ian Wace, co-founder of Marshall Wace Asset Management, put it at the 2000 Hedge Fund Symposium in London:
“This business (hedge funds) has nothing to do with positive compounding; it has to do with avoiding negative compounding… The P&L is the only moderator of hubris. You are not given money to lose it.”
When avoiding compounding capital negatively is a major objective, downside volatility and losses are of major importance. Large losses damage the rate at which capital compounds. Consider:
This is a big difference, especially if you wanted to retire at the end of year 10. It is losses, especially large ones that destroy the rate at which capital compounds. Paul Tudor Jones, founder of Tudor Investment Corporation and successful practitioner of positive long-term compounding of capital, recommends:
“I’m always thinking about losing money as opposed to making money. Don’t focus on making money; focus on protecting what you have.”
The discipline that aims to avoid or minimize large losses is called risk management. Europe is a good example of an equity market that has been compounding negatively for many of the last 15 years. Table 3 shows what large losses and periods of negative compounding do to the long-term compounding of capital. The table contrasts a long-only strategy in the European equity market with a proxy for a portfolio comprised of hedge funds that operate in a long-short fashion within the European stock market. The first two columns show total returns and the last two columns contrast two portfolios in the respective indices, starting at 100 in January 2000.
The funny thing is that hedge funds often underperform the stock market. In the example shown here, hedge funds have underperformed nine times out of 15, i.e., more often than not. But it doesn’t matter. The impact from negative returns for the long-only portfolio is so large that looking at underperformance misses the point entirely. It’s the performance in the difficult market environments that matter to long-term performance. A portfolio of 100 in European equities, including the reinvestment of dividends, at the beginning of 2000 rose to 134 by the end of 2014 – without the re-invested dividends, the market has fallen by 10% over this period. An equivalent portfolio in European long-short hedge funds went from 100 to 313 in the same time frame. Again, this is a big difference.
Many investors are currently giving their hedge fund managers a hard time for not keeping up with the stock market. Table 3 shows that hedge funds often underperform the stock market when the latter experiences double-digit returns. Some hedge funds marketers fight this argument by contending that long-short hedge funds try to deliver 80% of the upside but only capture 50% of the downside. This asymmetric return profile would guarantee long-term outperformance with less downside volatility but would also result in underperforming the stock market in up years. Imagine that European hedge funds had indeed delivered 80% of the upside and only 50% of the downside over the 15-year period examined in Table 3. This would have resulted in hedge funds underperforming the stock market in 10 out of the 15 years. However, the portfolio would have gone from 100 in 2000 to 199 by the end of 2014. This means – and this is a bit of an awkward thought – hedge fund marketers are too modest. In the real world, the portfolio went from 100 to 313, thus compounding at 7.9%, which compares to 2.0% for the long-only equity portfolio. Fig.1 shows the long-only, long-short, and the hypothetical “80%-upside/50%-downside” portfolio in graphical format.
One of the marketing one-liners in hedge funds is that “hedge funds produce equity-like returns on the upside and bond-like returns on the downside.” While this one-liner is tongue-in-cheek, it is not entirely untrue. The investment philosophy of hedge funds differs from that of traditional asset managers whose portfolio closely resembles a market or liability benchmark. Hedge funds care about not only the long-term compounded returns on their investments, but also how their wealth changes during the investment period. In other words, an absolute-return manager tries to increase wealth by balancing opportunities with risk and running portfolios that are diversified and/or hedged against strong market fluctuations on the downside. To the absolute-return manager, these objectives are considered conservative.
One hedge fund manager in the 1980s came to fame for a particular idea where he bought an option with 2% of the fund’s capital. That 2% position returned 30% of the fund’s whole principal. Theattraction of this way of investing is only partly explained by the 30% return, which, after all, could be a function of luck. The 30% return as a single headline figure does not tell us anything about the risk that was involved to achieve the return. The main attraction in this particular case was that the manager and his investors only would have lost 2% if the investment idea had not worked out. In other words, at the time of investment, the manager knew that if the world moved in a way he expected his profits could be unlimited; if he were wrong, he would only lose 2%. This example illustrates the idea of an asymmetric return profile: high, equity-like returns on the upside, with controlled and/or limited-loss potential on the downside. The discipline that can achieve such an asymmetry in asset management is active risk management. Investors who are long and unhedged need to remember that equity and bond markets can compound capital positively as well as negatively for many years in a row.