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.