Why now might be the right time to look at hedge funds

  • Hedge funds offer the potential for capital preservation, return enhancement and portfolio diversification.
  • Smaller hedge fund managers, in particular, can be more nimble in their investment approach.
  • Risk and liquidity levels may make some or all hedge funds inappropriate for certain investors.

Forward-thinking investors understand the benefits of rebalancing portfolios ahead of changing market conditions. It is intuitively obvious and yet incredibly difficult. Looking at just the past 20 years, many investors were significantly overweight equities in 1999 and again in 2007, only to endure two massive drawdowns. Few investors want to question why a certain strategy is so successful, much less question when a successful strategy will stop working.

Today it's the passive, long-only, daily-liquid products luring investors into a sense of eternal success. Other strategies, including hedge funds, have taken a backseat. So why, then, might now be a smart time to add hedge funds?

Smaller hedge fund managers can be more nimble in their investment approach.
AIMSTOCK | Getty Images
Smaller hedge fund managers can be more nimble in their investment approach.

The key for investors, as always, is to look forward. And while the recent past has been a great environment for long-only risk assets, hedge funds can provide several unique advantages for investors, including the potential for capital preservation, return enhancement and portfolio diversification.

Since World War II, the S&P 500 Index has experienced 10 distinct bear markets, with an average time frame between periods of five years.

Our current market rally has persisted now for eight-plus years, making it the second-longest period without a negative 20 percent decline since the Great Depression. The duration of this market rally, combined with historically elevated equity valuations, record-level margin debt and increasing investor complacency, strongly suggest that now is a good time to seek out strategies designed to protect capital in difficult markets.

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Hedge funds' ability to short stocks and dynamically deploy capital at different points of an economic cycle have enabled them to perform this role in the past. Specifically, investors might consider diversified, multistrategy funds with strong track records through recent tough markets (e.g., the summer of 2011, spring 2014, August 2015 and the first quarter of 2016), making sure to evaluate how a firm's risk management has evolved longer-term.

As with capital protection, investors have not faced the need to seek out return enhancement strategies recently, with the S&P 500 generating an annualized return of more than 17 percent since March 2009, compared to its historical rate of return of approximately 9.5 percent. At the same time, the "risk-free rate" (as measured by the three-month U.S. T-Bill rate) has hovered around 1.5 percent since the onset of the Central Bank interventionist policies, compared with a long-term average closer to 3.5 percent.

This has resulted in an expansion of the "equity risk premium" from roughly 6 percent to 16 percent, providing significant tailwind to long-only equity exposure.

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However, few would argue that these benign market conditions will persist indefinitely. Looking forward, investors should consider not only how to protect their downside but also how to enhance their returns with strategies designed to capitalize on idiosyncratic situations. Smaller hedge fund managers in particular can be more nimble in their investment approach, and specialist funds with sector or geographic expertise, such as long/short technology strategies or Europe-focused, event-driven funds, can offer alpha through their ability to navigate less-efficient markets.

A third portfolio-management axiom that has diminished in importance over the past few years has been diversification. Diversification only works when the correlation of securities within and across markets is not structurally elevated.

Interestingly, there has been a decrease in cross-asset correlation over the past few months, coinciding with capital flows and monetary policies finally starting to diverge across the globe. Increased exposure to hedge fund strategies designed to balance the risk/return profile of multi-asset class portfolios will only increase in value going forward. At this point in the market cycle, investors should seek out non-traditional trading strategies, such as reinsurance or systematic macro, that are structurally uncorrelated to equity and fixed income markets.

"Hedge funds can help protect client wealth, enhance returns and provide meaningful diversification."

Despite the benefits discussed above, hedge fund allocations — if improperly executed — can result in higher fees with little incremental value generated. Simply adding hedge funds is not enough – allocations must be managed to specific portfolio goals, manager selection is critical and access to a diverse range of strategies is key.

In addition, risk and liquidity levels may make some or all hedge funds not appropriate for certain investors. However, with the inclusion of high-quality managers, the right mix and number of funds, as well as alignment of interest with respect to fees, hedge funds can help protect client wealth, enhance returns and provide meaningful diversification.

As investors, we are often on the lookout for things that will one day "look obvious in hindsight." Though it would be nice if the markets continue to appreciate 10 percent, 15 percent or 20 percent every year, at some point the music will stop, as it always does. Preparing for that market shift is key, and while that is itself a challenge, investors who allow themselves to think differently may very well find themselves ahead of the pack.

— By Joe Burns, managing director at iCapital Network

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