For well more than a decade, the “endowment model” of investing has been synonymous with increasing allocations to alternative investment strategies, defined largely as hedge funds, private real estate, private equity and venture capital and other, generally less liquid or illiquid strategies compared to public markets.
This trend towards alternatives continued unabated until the financial market crisis, paused and then continued the growth path, albeit at a slower rate. Today, the largest educational endowments allocate on average more than half of their portfolios to alternative investment strategies. More broadly, non-profits of all types regardless of size have generally significant allocations to alternatives. Pension funds, while at much lower allocations, have likewise shifted assets toward alternatives in an effort to boost investment performance and dampen volatility.
Commonfund has long advocated allocations to alternatives to enhance returns and, for certain strategies, to provide diversified sources of alpha. We were among the earliest investors on behalf of our clients in hedge funds (1982) and private capital (1988). More than half of Commonfund’s approximately $25 billion in assets under management are in alternative investment strategies.
This begs the question: have investors been adequately compensated with higher risk-adjusted returns compared to traditional strategies over this period of growth? And, perhaps more important, what should investors expect from their allocations to alternative strategies in the future?
We believe that there is clear academic and empirical evidence that alternative investment strategies have contributed significantly to portfolio returns over the last 20 years. And we conclude that the fundamental principles that have contributed in the past to higher investment returns among alternative investment strategies, compared to traditional long-only equities and bonds, remain largely unchanged as we look to the future. As such, investors that allocate capital to alternatives – with the pronounced caveat that investment talent matters – should continue to exhibit higher performance in comparison to those institutions that allocate solely to traditional assets.
But in reference to the noted caveat, allocations to alternatives should be reserved for the investor that can access top-tier managers, since the distribution of returns among alternative managers is far greater than it is among traditional managers. So while a third or fourth-quartile equity or bond manager may not detract significantly from benchmark returns, sub-median (or in many cases even median) hedge funds and private capital managers will typically lag public indices.
Hedge funds are among the most enigmatic and mysterious of all of the strategies in the alternative bucket. It is also the asset grouping that has the highest allocation among alternatives in the non-profit sector; and for the largest colleges and universities, allocations to hedge funds are higher than they are to US equities at 19% versus 15%, respectively. For institutional investors, hedge funds came to the fore in the early 2000s when the internet bubble burst. In that period hedge funds were flat to up a little when the equity markets were down 20% or more. It was at that point that hedge fund asset growth really took off.
Today, hedge fund assets under management are at an all-time high, yet net inflows have fallen to 2-3% annually from 11% pre-2008. Fewer funds are being launched and two-thirds of the industry is now concentrated with managers with more than $5 billion in assets under management. Clearly, hedge funds are a maturing industry, but does that mean they are no longer a good investment? A recent Bloomberg Businessweek article, replete with provocative cover art and headline “Hedge Funds are for Suckers”, combined with recent weak industry performance relative to equity markets since the financial market crisis, and high-profile investigations by the SEC and others have all served to fuel the debate on the value and role of hedge fund strategies in institutional portfolios.
Let’s look back on the factors that helped propel growth in hedge fund strategies among institutional investors.
These have included:
The first hedge funds were, indeed, designed to hedge. At least two centuries ago, millers and grain merchants on the agricultural commodities exchanges in Europe took long and short positions in different but related agricultural markets to protect themselves from sudden adverse moves in the prices of wheat, oats and other grains in which they dealt. Over time, these principles began to be applied to trading in equities, bonds, currencies and other financial instruments.
The creation of the first modern hedge fund is often attributed to Alfred Winslow Jones, a former Fortune magazine writer. To reduce the effect of stock market fluctuations on his fund’s valuation, he both bought stocks and sold stocks short.
In large part due to the unregulated nature of hedge funds, hedge fund managers had tremendous investment flexibility. When we go back to the beginnings of hedge fund investing by non-profits in the early ‘80s, the concept was quite simple. There were clearly opportunities to go beyond the pale of the traditional long-only investor. For the right and skillful manager the ability to go long or short, to be unconstrained around investments, to look for opportunities wherever they may be, to leverage and take a longer-term time frame and not be forced into the consultant-style boxes created large advantages for those investors who truly had skills.
In addition, the alignment of incentives was a very appealing concept. The manager did not get rich unless the client did well. In the olden days hedge funds were relatively small with small and focused teams led by an investment guru. Over time the siren’s song of this structure was just too compelling for both investment professionals and institutions to ignore. If you were a good long-only investor or worked with a bank’s capital, how could you not want to escape the bounds of style buckets transparency, and high levels of compliance and oversight to a land where none of those things existed and you could work for 2% base fees (versus fractions of a percent) and 20% of the profit. For investors, achieving unconstrained, low-volatility, low-correlation, high returns, this was almost too good to be true.
Much of hedge fund investing in the early days was based on exploiting market inefficiencies; that is, having better information, tools or models that could take advantage of mispricings. Hedge funds have historically been a “skill” game where investors paid up for superior investment talent with the expectation of outsized returns compared to traditional long-only strategies.
Given the flexibility underlying hedge fund strategies, the ability to use leverage was viewed as another tool to enhance performance. Even in the early days of Alfred Winslow Jones, he employed leverage, borrowing money to invest in the portfolio and thereby increasing his long exposure. Certainly, among the most notable uses of leverage was Long-Term Capital Management which used aggressive trading strategies to exploit minute pricing anomalies – then used high levels of leverage to generate high profits, only to collapse in a flight to liquidity.
Hedge funds today
So what has changed in this category over the last two decades and how should we think about hedge funds in the future? There is probably not an area of investing that has had more growth in the last 20 years. The industry has gone from a small group of gurus working with a limited amount of assets with small focused staffs, to a huge industry with more than 10,000 hedge funds with $2.3 trillion under management. (See Fig.1).
There are now almost twice as many equity analysts working for hedge funds as for long-only managers. Successful guru-centric organisations have become mega-firms with multi-strategy approaches and hundreds of employees running billions of dollars. We have also moved from the concept of just hedge funds to a number of style boxes that define the underlying strategy focus. The current breakdown of the assets allocated to these style boxes are outlined in Fig.2.
So if hedge funds can generate good non-correlated returns (even after fees) doesn’t it make sense to allocate capital to this area? And, have hedge funds lived up to their promise? Let’s review the case against the drivers of growth two decades ago.
The growth and maturation of the hedge fund industry has led to a blurring of the diversification benefits in large part because many so-called hedge fund strategies over the two decades have been nothing more than high-priced beta exposures. As evidence, aggregate hedge fund correlations (as measured by the HFRI Fund Weighted Composite) relative to the S&P 500 index have risen steadily from about 40% to more than 70%.
However, a universe-wide look at correlations reasserts that the risk and return properties of a hedge fund allocation are not simply a function of the broad equity market. As the total number of funds has risen within the HFRI universe, so too has the number of funds that are highly correlated to broad equity markets. However, as noted in Fig.3, there has been a greater increase in the number of managers with less than 10% of their return explained by the S&P 500 Index than any other group. This tells us that diversification still lives, but the devil is in the detail for investors who seek to construct portfolios.
The benefit of diversification is also evident in the measure of downside protection and the power of compounding demonstrated in Fig.4. The chart illustrates that over the time frame from 1990 until today the HFRI index has outperformed both stocks and bonds, with much of the relative return benefit coming in that very difficult early 2000s period.
The downside protection benefit came during those periods where it was needed most in fiscal 2008 and 2009 where the average hedge funds used by colleges and universities were up only 3% and then down 12% versus the S&P 500 which was down 10.2% and 25.5% respectively in those two years. So despite all the hand wringing and concern (not to mention the number of billionaires created), hedge funds did what they were supposed to (although there will always be some who want them to do more). For the 10 years ending 30 June, 2012 the compounded return of the hedge fund portion of the average college and university was 5.48% net of fees. This was 15 basis points higher than the S&P 500 return for the same period. However, the key statistic may be that the annualised standard deviation was less than half of the S&P 500 at 7.6% versus 16.7% for the equity market index.
Capital scarcity and unconstrained mandates
The starting point in thinking about hedge funds going forward has to be the significant increase in the dollars being allocated to these strategies, increasing by about five times over the last decade. It is this cash flow that has transformed small shops with concentrated intellectual capital into behemoths with tens of billions of dollars to deploy. If in fact there are only so many mispriced positions in the market, the amount of capital chasing these mispricings should quickly identify and close any discrepancies. This would certainly support the argument by some that future long-term returns among hedge funds will not be worth the fees they charge. Further, with industry consolidation, many of the funds have become large businesses and the near-death experience that hit the industry in 2008 and 2009 has management teams more highly focused on maintaining the business than generating high rates of risk-adjusted returns. Looking to the future, finding those managers that are not too small to support the infrastructure necessary under Dodd-Frank, but not too big to be able to find opportunities where size does not overwhelm mispricing, becomes the critical task.
Related to the point above regarding the risk of too much capital chasing too little opportunity is the question as to whether or not skill still matters, and whether top-tier hedge fund managers are still capable of generating consistent alpha (and not beta cloaked as alpha). In a 2011 study by Ibbotson, Chen and Zhu published by the CFA Institute, the authors concluded that hedge funds generated 300 basis points of alpha per annum in the period from 1995-2009. This study represented an update to the 1999 study by Brown, Goetzmann and Ibbotson which found statistically significant alphas in the hedge fund industry from 1989-2009. The 2011 study also concluded over the 15-year period that each of nine underlying hedge fund strategies contributed positive annual alpha.
The expectation of double-digit returns from the hedge funds with very little downside risk is a thing of the past. It is a manager skill game that should provide returns that are over the bond rate but below the equity markets. The good news is that they still should provide downside protection in difficult market environments and compound at a rate of return even after fees that is in line with the equity markets. As to individual managers and strategies the effective use of this becomes paramount. Being able to shift between the various style buckets based on market conditions should enhance returns over the benchmarks.
A recent headwind to hedge fund performance is the very low interest rate environment. Hedge funds earn interest (called rebates) on short positions and pay interest on margin amounts. Since many long/short hedge funds today do not add a lot of leverage, the interest on the shorts serves as a value enhancer to the return. With interest rebate near zero and in some cases having to pay interest in the shorts will reduce the overall returns of the funds. Normalised interest rates will likely reduce this headwind in the years to come.
Notwithstanding some claims otherwise, hedge funds have largely delivered on the promise of diversification, downside protection and the resulting benefits of positive compounding over the last two decades, the period of the financial market crisis included. But the industry is in the midst of significant regulatory change, and the last four years since the financial market crisis (coinciding with the fifth strongest US equity bull market in history) has given pause to some investors who (unrealistically) expected hedge fund strategies to keep up more effectively with this raging bull.
The impact of Dodd-Frank remains unclear, but could actually be a net positive. The Volcker Rule – a section of the Dodd-Frank Act – and other capital-focused regulation has really taken the banks out of the hedge fund business both in terms of sponsorship and trading bank capital with a hedge fund approach. In days past banks and investment banks used a significant amount of their own capital to perform hedge fund-like activities. The trades may have been done in trading books assisting with customer flows or in stand-alone trading strategies. Today many, if not all, of these activities have been curtailed, partly owing to the fact that these companies are now public and subject to earnings disappointment, and more recently Dodd-Frank and Basil III since the crisis. It is difficult to estimate how much bank and investment bank capital has left the market as a result of this major change in the regulatory environment.
The second tail wind is the cost of transacting in public markets. The transition over the years to electronic trading platforms has significantly reduced the cost of trading in the public exchanges around the world. This has led to higher volatility in the markets. However, with banks leaving market-making activities in some of the less liquid markets (the OTC bond and derivative markets) the cost may increase going forward. The addition of a liquid ETF market has made the ability to hedge a lot easier and cheaper. This development means that short positions can be taken much more cheaply and with great cost efficiency.
Historically, alternative investment strategies have delivered on their promise. Private equity and venture capital have provided returns well above public market equities, and hedge funds have provided alpha across market cycles and have protected in down markets. Furthermore, this performance has held true on a net-of-fees basis.
But these statements are not without qualifers. Most important, investment talent is key, as median performance is less likely to provide consistent outperformance relative to traditional long-only strategies. So deploying capital with top-tier investment managers is necessary in order to achieve attractive risk-adjusted returns.
So what does the future hold for alternatives? We believe that the fundamental principles and drivers of investment performance that have propelled returns for alternatives over the last two decades are largely unchanged. While it is true that there is more capital in these strategies and that there are many more managers, allocations to these strategies as a percentage of global equity market capitalisation remain relatively small. But the one truism of the past is even more pronounced today: an “index-like” approach to alternative investment strategies will certainly disappoint.
Perpetual and other long-term asset pools such as endowments and foundations and pension funds have not been able to maintain purchasing power over the last generation by simply allocating to a basic mix of passively managed equities and bonds. Active management of long-only strategies will only bridge part of the gap. As such, we believe that significant allocations to alternative strategies – thoughtfully constructed, with top-tier managers – are necessary to preserve intergenerational equity and thus fulfil the long-term missions and obligations of institutional investors.
The “right” allocation to alternative strategies, often a function of the level of illiquidity an institution can maintain, is among the most important decisions facing governing boards and investment committees today.