Total capital invested in the global hedge fund industry has recently increased to $2.97 trillion, rapidly approaching the $3 trillion milestone. In conjunction with this, hedge fund performance has improved in 2015, with the HFRI Fund Weighted Composite Index, the leading benchmark of hedge fund industry performance, outperforming US equities in 1H15 by posting a gain of +2.5% while the S&P 500 gained +1.2%. Though the magnitude of the outperformance may seem modest, it represents an important inflection point in hedge fund performance as global investors discount the ending of US Federal Reserve stimulus measures (QE) with important implications for hedge fund performance in coming years.
The historic era of US Federal Reserve quantitative easing is quickly drawing to a close, and with much speculation around the exact timing of US rate increases, asset prices appear to have largely discounted these increases across US equity markets, US dollar, gold and emerging market fixed income. The curtailment of QE measures in the US is likely to have broad implications for hedge fund performance in coming years as many of the fundamental macroeconomic drivers of hedge fund performance shift from the past five years and are allowed to return to market-clearing equilibrium levels.
Hedge fund performance is often measured against the performance of the S&P 500 as a measure of the opportunity costs of investing, though the comparative relevance of this relationship diminishes quickly upon additional scrutiny. It is worth reminding ourselves that this is primarily a comparison of convenience as the HFRI reflects exposures both long and short, as well as exposure to multiple asset classes from fixed income, currency, commodities and emerging markets to nearly every type of equity market exposure from US large-cap equities downwards. Since the vast majority of hedge fund investors have 90-95% invested in equity and fixed income exposure, allocations to alternatives are not thought of as a discrete choice between these, but a strategic complement designed to reduce portfolio exposures under periods of adverse performance or financial market stress.
Since 1990, the HFRI FWC has outperformed equity markets, with the HFRI gaining an annualized return of +10.5%, while the S&P 500 has annualized +9.5%. However, the HFRI has trailed the S&P 500 in the past five years, with the S&P 500 posting an annualized gain of +15.4%, while the HFRI has annualized a gain of only +5.0%. A decomposition of hedge fund performance from 1990-1999 (First Decade) provides some interesting insights on performance expectations for coming years through the post QE environment. In this First Decade of HFRI performance, the HFRI gained +18.3% annualized, nearly identical to the +18.2% of the S&P 500 – both impressive returns, but the HFRI significantly outperformed on a risk-adjusted basis, posting an annualized volatility of 6.9%, roughly half of the S&P 500 volatility which was +13.4%. The performance of equity markets over the past five years has mirrored the strong returns of the 1990s, although the performance drivers have been very different, with a large contribution from US Fed QE stimulus measures. As such, the relative performance of equities and fixed income (versus hedge funds) over the past five years is more a story about unusually and historically high equity-market performance and less one about low hedge fund performance, per se.
While equity market performance is a significant contributor to hedge fund returns, the performance and level of bond yields – both government and corporate – also have a significant impact. US interest rates, as measured by 10 year Treasury yields, peaked in 1982 and began the 1990s around 8%, averaging over 5% for the next decade. Furthermore, US inflation averaged 5.4% throughout the 1990s, while high-yield credit ranged upwards from 600 basis points over treasury yields. Both of these are in stark contrast to persistent historically low interest rates and non-existent inflation of the present time. The gaping differential in “carry” alone between current levels and First Decade levels, even on an unlevered basis, could account for 500 basis points towards aggregate hedge fund industry on an annualized basis, a number which could be significantly higher with even modest application of leverage. The important consideration is that while both absolute performance (i.e., positive performance above zero vs. negative) and relative performance (i.e., benchmarked to equity markets) provides a certain relevant context, investors should also formulate expectations for hedge fund performance as a multiple of the risk-free rate, with expectations of being compensated for risk taking above this important threshold. Applying this logic to ex-post performance, clearly there have been many years in which realized hedge fund performance exceeded a multiple of the contemporaneous risk-free rate, both historically and recently. With risk-free rates as low as the present, even exceeding this threshold did not result in performance above the ex-post realized return in equities over the past five years.
In addition to the absolute level of yields, another important consideration as a driver of hedge fund performance is the correlation between equity and fixed income performance, with recent results clearly influenced by stimulus measures. Throughout the 1990s, and particularly in the 5-year period of 1993-1998, equities and fixed income had a negative correlation of -0.2 as bond prices declined, equities rallied and hedge funds annualized gains of +18.2%. Historic data over shorter periods is even more compelling. By way of example, in the 12-month period from 4Q 1998 through 3Q 1999, the HFRI FWC returned +23.3%, with negative correlation between Treasury yields and equities averaging -0.7, and equities gaining while bond prices fell. Over the past five years, this correlation has turned positive to approximately +0.2, as QE measures have driven both bonds and equities higher; an unusual macroeconomic relationship and one viewed with a certain unsustainable skepticism by many hedge fund managers. Consider the prospects for the classic hedge fund strategy, convertible arbitrage, with historical US yields at 6% and high yield credit trading +600 basis points over Treasuries. With only a modest application of leverage, this strategy offers very favorable return dynamics, including positive carry, long volatility and strong downside equity protection. The opportunity is very different for managers in the current environment, with minimal absolute carry and positive correlation between equity and fixed income. Ceteris paribus, with the benefit of hindsight, the equity/bond disconnect has been difficult for managers of hedged strategies to position for, with expectations either that yields were too low to be consistent with equity valuations, or that equities were too high to be consistent with bond yields. Positioned accordingly, hedge fund gains of the past five years against the powerful backdrop of QE stimulus have been below the two long-only ‘camps’: equity index funds and long-only bond funds. However, as presented above, this result is more a function of the powerful beta trends in these assets over a historically and unusually strong period of performance, which is not likely to be repeated in coming years.
Some would speculate that the growth of the hedge fund industry to $3 trillion has increased financial market efficiency via high frequency algorithmic trading and other means, reducing the opportunity for performance-generated gains across the industry and suggesting investors should expect lower performance as a result indefinitely. In this manner, one would suggest that the attributions of recent performance were more structural than cyclical. Unfortunately, the evidence to support such a hypothesis is weak on multiple counts. In order for this to be true, one would invariably need to conclude that highly efficient financial markets at present were largely inefficient just a short time ago. While financial markets are indeed efficient at present, the sum total of hedge fund capital growth to $3 trillion, an estimated 1% of total global assets, has not been solely and independently responsible for this progression toward efficiency. This hedge fund industry growth efficiency attribution argument is also weakened when considering the pools of capital managed in traditional asset classes and the levered capital balances utilized in proprietary trading by institutions. Nor would this explain how the growth of the mutual fund industry, roughly four to five times the size of the global hedge fund industry and with a significantly longer history, would not have had a more profound impact on market efficiency from an earlier point in time.
As every investor knows, past performance is no indication of future results, but the relevant question for investors in 2015 is: what circumstances or similar historical context could or should be considered as fundamental driver of asset performance? Should investors expect a repeat of the past five years for equity and fixed income markets, or might the next five look different? To what extent will the next five years look more like the last five years, or more like the 1990s, from the perspective of the macroeconomic drivers of hedge fund performance?
I submit that while the next five years may not look exactly like either period, as the post-QE financial market normalization continues, higher nominal interest rates and mean-reverting historical correlations between equities and fixed income are expected to deliver strong hedge fund performance, driving the HFRI Fund Weighted Composite Index to a Net Asset Value (NAV) of 25,000 by 2021.
Kenneth J. Heinz, CFA is the President of HFR (Hedge Fund Research), managing HFR's hedge fund index business, including the HFRI, HFRX and HFRU Indices. He has provided specialized consulting services to many of the industry's institutional investors & hedge funds. Heinz holds an MBA from U. of Chicago Booth School of Business, as well experience as a trading member of CME, CBT and CBOE.