December 2011
Monthly Investment Commentary
Despite a great deal of intermonth volatility driven by the
ongoing European debt crisis, U.S. stocks ended November
basically unchanged. Looking abroad, developed international
stocks were impacted more significantly by the events in
Europe, and lost 4.6% in November, while emerging-markets
stocks dropped 3.4%.
Fixed-income markets told a similar story in November, with
high-quality domestic bonds down 0.3% while international
bonds fell 1.5%, and emerging-markets bonds lost 3.4%. See
table for further November benchmark returns.
As the European situation approaches a crisis, it increases the
chances of our most negative “deflation” scenario playing out
over the next several years, and raises the risk of significant
shorter-term downside for risk assets. And though we don’t
consider it the most likely outcome, the impact on our portfolios
would be severe enough if it did occur that we think it’s prudent to
reduce risk in our balanced portfolios. Therefore, we are
incrementally reducing our equity positions in favor of investmentgrade bonds. See our separate analysis of the euro debt crisis for
more thinking on this topic.
Seeking Absolute Return:
Finding Opportunity in Overly Hyped Alternatives
Eight years ago we published a lengthy white paper on hedge-fund investing. Back then, our interest in
hedge-fund strategies was triggered by our concern that stocks and bonds were priced to deliver belowaverage returns and expose investors to above-average risk. In theory, hedge funds could offer an
alternative place to hang out, capturing decent returns with less volatility, while waiting for better
opportunities in traditional financial assets. The appeal was particularly tempting among what are commonly
referred to as “absolute return” types of strategies.
Today, we have similar concerns about stocks in the context of the deleveraging taking place in most of the
developed world. As we’ve discussed previously, deleveraging creates a headwind for economic growth, and
high debt levels make for a much higher-than-normal global risk environment. These debt-related problems
also increase the odds of economic policy errors that could make things worse. We don’t believe stock prices
are reflecting some of the risk scenarios that could play out. And, the low yields paid by high-quality bonds
make the other core financial asset class a very low return investment over our five-year investment time
horizon. Given these concerns, private hedge funds or a growing number of mutual funds that use hedge fund
strategies, in theory, could have great appeal.
But, theory can be difficult to apply in the real world. As we concluded eight years ago, hedge fund strategies
do have the potential to add value to a portfolio. However, finding funds that are skillfully managed and offered
at a reasonable cost is a requirement for success and this is not easily done. Our 2003 study noted the
obvious, that investors and financial advisors would find it very difficult to capture the promised benefits from
hedge funds because of practical impediments to investing. Most quality hedge funds have very high minimum
required investments and also require that investors meet qualified purchaser criteria. Their lack of daily pricing
and liquidity and limited transparency were also major practical issues. But there are also more fundamental
problems with many alternative strategy funds.
Beyond the practical impediments to investing there were several factors that undermined the ability of many
hedge funds to deliver on their investment objectives. These objectives, though described in various ways,
were essentially to add portfolio alpha via low volatility, low correlation to stocks and bonds, and a healthy
Sharpe Ratio (a measure of risk-adjusted performance). In short, these funds seek to offer investors
relatively low-risk vehicles that could generate better returns than a stock/bond mix and smooth portfolio
volatility partly due to low correlation with stocks and bonds. Eight years ago our concern was that three
factors would make it difficult to achieve these objectives. These concerns remain unchanged today:
COST
Fees in the hedge fund world generally range from 1% and 20% of profits, to 2% and 20% of the profits (the
first number refers to a percent-of-assets fee and the second is the percent of return that is paid to the fund
manager as an additional incentive fee). Investors accessing a diversified hedge-fund strategy via a fund of
funds, pay yet another layer of fees, usually around 1% and often including a performance fee of 5% or 10%.
In total, fees could reduce a gross return of say, 12%, to around 6% in a fund of funds. In the mutual-fund
world, the cost structure of these hedge-fund-like strategies is different and generally lower, but high fees are
still common. There is usually no performance fee (in the fund world, performance fees have to be structured
as a fulcrum fee which is less appealing to fund management), but fixed fees are higher, often around 2%.
These high fees obviously translate into the need for extremely high pre-fee returns in order to deliver a
competitive after-fee return to investors. Some funds are able to generate the returns to overcome the fee
headwind, but many do not.
RETURN DRIVERS
When we did our study we believed future hedge-fund returns were likely to be lower than in the past for
several reasons. First, absolute-return-oriented funds on average do have some beta, so a portion of their
return is market driven. Low market returns suggest hedge funds will earn lower returns than they otherwise
would. Second, so much money was flocking to alternative strategies that we feared they might become
crowded, resulting in lower returns from increased competition. Both remain concerns today.
RISK
We believed the level of risk was understated, with hedge-fund correlations having a tendency to rise during
periods of extreme market volatility so that downside risk would likely disappoint investors. Disappointment
could be especially high for investors in the many funds that were marketed as absolute return, a moniker that
implies that positive returns could be captured in any environment. While we believed a diversified portfolio of
hedge funds should hold up much better than stocks in a bad bear market, we continue to believe they will not
provide the degree of diversification benefit of investment-grade bonds.
Still, we did believe that for some investors and financial advisors, it was possible to put together a value added hedge-fund portfolio, but it would take expert due diligence work to find truly gifted managers who
could deliver compelling after-fee performance. It would also require a large capital base. Smaller investors
could try with mutual funds, but eight years ago we did not believe there were enough quality funds wi th
which to build a portfolio. Today there are many more available funds, but quality funds are, in our view, few
and far between.
Today, our concerns are unchanged from eight years ago when we completed our study.
So What Happened?
Since we wrote our paper the hedge-fund world has played out as we expected.
RETURNS
Measuring hedge-fund industry performance can be
challenging. There are many hedge-fund composites and
(as noted in our 2003 white paper) there are many
reasons to suspect that the numbers reported by most, if
not all, of the benchmarks are at least somewhat inflated.
With that caveat, a benchmark we follow to track industry
performance is the HFRI Fund of Funds Diversified
Index. This tracks performance of professionally
managed funds of funds and as such represents the
efforts of firms that market themselves as having skill in
selecting well-run hedge funds. Since 2003, when we
wrote our paper, the return on this benchmark is only
2.8% through September 30, 2011 (this includes several
months of estimated returns from HFRI). As a frame of
reference, over the same time period a 65%/35%
stock/bond portfolio returned 3.7% and a 35%/65%
stock/bond portfolio returned 4.6%. (Note: Some may
quibble with our use of a fund-of-funds index because of
the return dilution from the layering of fees. A rough
adjustment would be to add 1% to these returns, which would bring them up to the level of the balanced
portfolios.) Over this time period, the relative returns for hedge funds were disappointing.
RISK
We tend to focus more on absolute measures of risk, but we also pay attention to volatility. Since writing our
white paper (through September 30, 2011), the standard deviation for the HFRI index was 5.8%. This
compared to 15.3% for stocks, 3.5% for bonds, 10.1% for the stock-heavy balanced portfolio, and 6% for the
bond-heavy balanced portfolio. So, based on volatility the risk of hedge funds was (as expected) between
stocks and bonds and similar to the more bond-heavy balanced portfolio. However, in the 2008 market,
looking at the magnitude of losses, performance was less impressive. In that year the HFRI index declined
by 20.9%. This was much better than stocks (down 37%) and much worse than bonds (up 5.2%). It was also
better than the stock-heavy balanced portfolio, which fell 24.1% but quite a bit worse than the bond-heavy
balanced portfolio which declined 11.4%. This was consistent with our expectation that correlations would
rise in highly stressed illiquid markets resulting in worse than expected losses from hedge fund strategies.
This was particularly troubling for investors who owned hedge funds expecting them to minimize losses in
down markets (the absolute return expectation). The losses may also have been driven by the explosive
growth in hedge funds (both assets and number of funds) in recent years that resulted in many hedge funds
owning similar assets. When volatility rose (along with fund redemptions) many funds were forced into
selling the same assets at the same time.
FEES
Fees remain very high and may have even increased on average prior to the 2008 market meltdown. Strong
hedge-fund demand has allowed successful funds to raise their fees and some newer funds have piggybacked
off this trend. At the time of our 2003 study, fees ranged from 1% and 20% of profits to 2% and 20%. These
days, the “norm” skews closer to the higher end of that range. In the mutual-fund world, fees are also high. In
Morningstar’s Multialternative category (which tracks hedge-fund-like mutual funds that deliver more than one
strategy in a single fund), these funds have an average net expense ratio of 2.02%.
EXCEPTIONS
On average the industry performed in line with our expectations, which is to say that the performance was
neither exciting nor a game changer for investors. However, as we also expected there were a number of
funds that performed very well.
Our conclusion eight years ago was that hedge funds could add value, but only for advisory firms with due
diligence expertise and clients with enough assets to allow for adequate diversification. We also wrote that we
may get to the point where there are enough quality public mutual funds running hedge-fund strategies to build
a portfolio for a broader group of clients.
More recently, we invested in two mutual funds in our broader portfolios that run hedge-fund strategies
including two arbitrage funds (the Arbitrage Fund and AQR Diversified Arbitrage). Both of these funds have
reasonable expenses and have delivered the low volatility we expected.
What is Different in 2011?
The primary difference today versus eight years ago is
that there are more mutual funds running hedge-fundlike strategies. However, the vast majority we have
looked at have not been compelling. We recently
looked at Morningstar’s Multialternative category,
which, tracks hedge-fund-like mutual funds that deliver
more than one strategy in a single fund. The category
includes a number of multimanager funds as well as
some single-manager funds that cover multiple
strategies. As of the end of September 2011, there
were about 76 funds in the category. However, only 24
had at least a three-year record, which speaks to the
newness of hedge-fund strategies in the public fund
world. Overall, the category’s performance has not
been compelling. Over three and five years through
September 30, 2011, the category average underperformed balanced benchmarks on a return basis. In
terms of volatility it was similar to a bond-heavy balanced portfolio. However, it underperformed this
benchmark in every declining market period we reviewed over the past three years. (As to the exceptions,
only one fund really stood out relative to the balanced index benchmark—a fund of funds with a 2.5%
expense ratio, not including the expenses in the underlying funds. We have not resear ched this fund.)
In our view, alternative strategy mutual funds suffer from the same problems that hedge funds in general do—
plus, their fee level is still high enough to present a material performance headwind. In addition, we are
skeptical of the quality of the management of many of the mutual funds employing hedge-fund strategies.
While we have not looked at all, most that we have researched were not impressive. And, we continue to ask
the question we asked years ago: If a hedge fund manager is really good, why work for significantly lower fees
in the mutual fund world?
As we wrote in March 2010, while adding absolute-return-oriented strategies to a portfolio may seem
compelling in theory, we believe the devil is in the details: Evaluating the risk and return characteristics of
each type of strategy (there are a wide variety of strategies that fall under the absolute -return-oriented
umbrella), each manager’s investment process, and their skill in executing their strategy. While the
overall category has not impressed us, there are some good firms and funds in the flexible -fixed income
area (Osterweis Strategic Income and PIMCO Unconstrained, for example), and as mentioned earlier,
there are at least a couple of arbitrage funds we like and have invested in (AQR Diversified Arbitrage and
the Arbitrage Fund). More alternative-type funds are hitting the mutual-fund market every day and we
expect to continue to see a lot of mediocrity, but also hope for the occasional winners.
Important Takeaways
Clearly investors have a high level of interest in alternative funds—anything that is expected to provide
diversification, lower risk, and ultimately add to risk-adjusted return is in demand. Money flows make this
obvious in the private fund world with hedge funds continuing to attract assets along with other alternative-type
funds. In the mutual-fund world, alternative-oriented funds are also experiencing high asset flows and many
new funds are being launched.
It is encouraging to see more options in the mutual-fund space, making these strategies more accessible to
the majority of investors and small institutions. And, we believe in time there will be more quality options
available, though we are skeptical that there will be many. But, ultimately, quality management and
reasonable expenses are necessary for investment success. We are willing to pay higher fees up to a point.
But, in doing so we must be convinced that we are accessing managers with a skill level that can not only
deliver on the risk management expectations (which have to be realistic) but also can deliver the alpha in
terms of risk-adjusted return to add value to what we can already do with traditional asset classes. The fact
is, generally these funds have not been able to add value relative to the equity/bond index we typically
compare these funds to. We attribute that to the fees and management execution.
Many funds are trying to take advantage of investors’ clear desire to find something more compelling than
traditional long investments in equities and bonds. A typical approach is to build a diversified portfolio
made up of different alternative buckets. Again, the problem is in the execution, with management unable
to deliver the performance to make up for high fees and ultimately meet the fund obje ctives. Investors are
right to look at the alternatives world given the macro risks and potential return scenarios for stocks and
bonds. But, if investors want to be successful investing in the alternatives world, they must be more
demanding with respect to the quality of the investment managers they are hiring. Adding alternatives just
for the sake of having them is not enough.
Dave Repka and the CFS Research Team