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Hedge funds for all seasons

8 Jul 2020

Tom Kehoe is global head of research and communications at the Alternative Investment Management Association (AIMA)

Comparing the current crisis to previous market corrections, it is worth recalling the collateral benefits of investing in hedge funds. A hedge fund constitutes an investment program whereby the manag- ers seek absolute returns by exploiting investment opportunities, while protect- ing principal from potential financial loss.

As of the end of the first quarter this year, leading stock market indices lost between 13% and 20% of their value with the MSCI World index (a popular equities proxy used to compare hedge fund perfor- mance) losing 14% of its value. Similarly, the value of a balanced portfolio (com- prised of a 60% allocation to equities and 40% to fixed income investments) fell by approximately 10%. During the same pe- riod, the average hedge fund was 6% down on the year.

To put it another way, during this most recent correction, hedge funds halved (or in some cases reduce by even more) the losses incurred by those invested passively in equities or fixed income assets.

Looking at previous market corrections, hedge funds have consistently demon- strated that they are able to manage these periods for investors better than anyone else. Taking the most recent example of 2008’s global financial crisis, the 20% loss incurred by the hedge fund industry compares favourably to the average stock indices that lost half its value.

Further, the average hedge fund recov- ered its high-water mark (i.e. recovered its losses) by October 2010, whereas a bal- anced fund did not recover its losses until March 2013, some two-and-a-half years later.

Hedge funds serve a wide range of pur- poses in investors’ portfolios, extending beyond alpha generation. Many of the most experienced allocators worldwide no longer consider hedge funds as separate from the traditional assets in a portfolio but as substitutes for long-only invest- ments and diversifiers capable of trans- forming the risk and return characteris- tics of their entire investment portfolio. Take the substitutes. Deploying certain hedge fund strategies as a substitute or complement to an underlying portfolio of equity or credit investments can help the investor to dampen overall portfolio risk as well as preserve its capital value.

Some hedge funds are simply too uncor- related to equities, say, to be a straight swap − since the way they behave under certain market conditions is substantially different to the way the underlying asset class behaves.

These are the diversifiers, providing the highest possibility of generating out-performance.
Deploying certain hedge fund strategies in the role of a diversifier can help the investor to access new markets (private assets, for example) and investments that have the potential to produce out-performance and can offer a less correlated source of returns to a portfolio comprised of bonds and equities.

In times like we are currently experiencing, where financial markets exhibit increasing levels of uncertainty and volatility, investors should consider increasing- ing their allocation to unconstrained investment strategies like hedge funds.

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