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Hedge funds have long been used by investors to access and unlock a number of potentially key benefits while building a well-diversified portfolio. To begin with, they may have the potential to provide positive returns in both rising and falling equity and bond markets.[1] Additionally, they can allow investors to access a variety of disproportionate returns through exposure to non-traditional or unknown risk factors, resulting in alpha.[2] Given this, they can help improve the return stability of an overall portfolio, as well as provide protection against broad market declines. Below, we examine how hedge funds have performed against global equity markets since the turn of the century to uncover the potential for investors to realize these gains.[3]
same destination, different journey
Over the past 22 years both hedge funds, as represented by the HFR Fund Weighted Composite Index (HFRFWCI), and global equities, as represented by the MSCI All Country World Index (ACWI), have lost approximately 3.5 times their initial value. given return. However, the chart below highlights that for most of the observed period, hedge funds outperformed global equities. This benefit was generated by lower declines in times of financial crisis, such as the GFC of 2008, combined with lower levels of hedge funds’ overall volatility relative to equities. These factors appear to have contributed to the hedge fund’s ability to maintain returns through the end of Q1 2021, when global equity returns closed the lead on hedge funds due to a quick recovery from the depths of the pandemic. .
The factor driving the dispersion gap was
As noted above, it appears that the lower overall volatility in hedge funds compared to global equities has been attributed to the improved performance trajectory. If we split the returns into a 36-month return series, we can see how pronounced this performance dispersion was. As seen in the chart below, in the early 2000s, equities began to rise out of the dot-com bubble, averaging less than -15%. Looking at the performance of hedge funds at the same time, we note that there were only two periods in which performance was highly negative. The first decline was in February 2009 at the bottom of the global financial crisis (GFC) and the second in April 2020 at the depth of the pandemic. In both the cases the negative performance reached to -1.4% and -0.2% respectively. This compares favorably to global equities, which also experienced two periods of negative performance, but did so for both longer periods and to a greater extent. The decline was -18.9% and -14.6%, respectively.
The discovery of this data leads us to believe that over the rolling 36 months, hedge fund investors may not have lost money if they made an initial investment in HFRIFWCI, although it should be noted that it is not an investable benchmark. Because it is not an investable benchmark, it brings to light the importance of manager selection when building a hedge fund portfolio. In addition, the hedge fund’s low spread in rolling 36-month returns would have helped reduce overall portfolio volatility.
consistently low volatility
Using the same time frame, we also looked at hedge fund volatility in relation to global equities. Hedge fund volatility was consistently lower than global equities, averaging 5.5% compared to global equities, which saw 14.1%. That’s an average relative volatility gap of 8.6%, which is pretty wide. It is also interesting that global equities displayed the highest volatility level during January 2011, when the MSCI ACWI Index saw a return of 24.1%, nearly three times higher than that of hedge funds at the same time. As noted above, this low overall volatility experienced in hedge funds can be attributed to the diversification benefits that hedge funds are typically equipped to provide.
Diversification of Systematic Risk
The last factor we look at in comparing hedge funds and global equities is beta. Beta is a commonly used measurement that determines how closely an asset moves relative to the broader market or a specific index comparison. Given the beta between hedge funds and global equities, it may be valuable to examine how hedge funds can further diversify the systematic risk associated with the broader markets. A beta of less than 1.0 generally indicates that hedge funds are less volatile than global equities, which we have already addressed by noting overall volatility, which is historically low in hedge funds. In addition, adding a hedge fund to a portfolio that already includes global equities can realize a diversification advantage and a reduction in broader market volatility.
This analysis also attempts to dispel a common misconception that hedge funds should outperform equities, in all market conditions. Given the low overall volatility and sub 1.0 beta, it will be difficult for a hedge fund to consistently outperform global equities outside a risk-adjusted basis. This does not mean that hedge funds are unable to outperform equities, but rather a specific expectation of a hedge fund is to provide consistent risk-adjusted returns in all market conditions.
all together Now
So what does this all mean? If we look at the top 10 drawdowns in the MSCI ACWI relative to the performance of the hedge fund, we see that in each of these periods, the hedge fund outperformed on a relative basis, albeit with negative absolute returns – the drawdown is shallow in each instance. Were. , This highlights the strong belief in investing, that diversification can be the only free lunch. While hedge funds are not a panacea for overall stock market volatility, they can be a powerful diversification tool that can increase a portfolio’s return as well as provide a diversification advantage that can reduce overall volatility.
Given the outlook for equities, and given the above analysis, it may be a good time for financial advisors to consider the allocation of hedge funds to see the broad benefits they can provide.
For more information on hedge funds and the potential opportunities available on the CAIS platform, Contact CAIS Representative,
