Hedge funds will come to the AID of investors over next decade
Hedge fund returns for 2021 are forecast to be lower due to lower public market performance, but despite this improved operating conditions should be supportive for most hedge fund strategies to generate alpha.
This is one of the key assumptions proffered in JP Morgan Asset Management’s 25th annual edition of its Long-Term Capital Market Assumptions.
The purpose of the report is to take a long-term view of the markets (both traditional and alternative) over the next 10 to 15 years, as investors appraise their institutional portfolios and think about the mix of long-only and alternative investments.
“The idea of this paper is to encourage investors to adopt a new portfolio for a new decade. Our long-term growth projections have not changed much but over the next 10 to 15 years we see fiscal and monetary policy moving in the same direction,” says Pulkit Sharma (pictured), Head of Alternatives Investment Strategy & Solutions and one of the report’s editorial authors.
As a result of higher valuations, public equities are expected to experience compressed returns next year. This will be most stark for US large-cap equities, where the return forecast falls 140 basis points to 4.10 per cent. This pulls global equity returns down by 140 basis points to 5.10 per cent, while the LTCMA team’s global equity ex-US forecast is down 70 basis points to, to 6.5 per cent; in other words, expect to see wider dispersion between US and non-US equities.
US aggregate returns are forecast to come down from 3.1 to 2.1 per cent.
“It is unusual for a new cycle, a new decade, to start with compressed asset valuations,” says Sharma, “especially on the fixed income side of the spectrum where long-term inflation is 2 per cent and aggregate returns are 2.1 per cent; on a real basis, that is where a lot of the challenges lie for investors over the next decade.
“Traditional asset allocation techniques (mean-variance optimisation) that rely on historical expectations for returns, volatilities and correlations will be challenged in this environment.”
If the stock/bond frontier in investor portfolios (the typical 60/40 mix) shrinks over the next decade, it will become even more incumbent for investors to look towards alternatives and active management, in general terms, to meet their ongoing long-term liabilities.
“We refer to alternatives coming to the AID of portfolios: Alpha, Income and Diversification,” explains Sharma.
“From an income perspective, I and D are already correlated to income-producing core real assets (i.e. real estate, infrastructure) that are significantly mis-priced and today offer 2x the income of US Agg, with significantly lower volatility than equity markets. They also provide a good inflation hedge over the next decade.”
Fixed income headwinds
On the hedge fund side, the focus for investors will be on the A &D: alpha and diversification.
From a European bond perspective, diversification is more and more challenged because base rates are so low.
The LTCMA paper forecasts normalisation over the next two to three years, “which we view as a bigger headwind to the fixed income market as rates rise from a very low level,” says Sharma.
“We think the ability to short in this environment will be very powerful. The building blocks of hedge funds are beta plus alpha but there are conflicting forces at work: while the long-term beta has become compressed in both equity and fixed income, there are a lot of structural factors where we think the operating conditions for generating alpha will improve.”
If one looks at the return assumptions for relative value hedge funds, they fall 90 basis points from 4.50 per cent in 2020 to 3.60 per cent in 2021. As referenced above, US Aggs is forecast to return 2.1 per cent, generating a combined return of 5.7 per cent. This is where RV hedge funds can play an important role as a bond diversifier, generating higher Sharpe Ratios and a higher premium than traditional fixed income.
“On the equities side, returns have compressed significantly. Our US large-cap equities forecast is 4.1 per cent. Earning 3.6 per cent with a median RV hedge fund is 50 basis points short of US equities but with less than half the volatility of equities. Overlaying the delta between top quartile and bottom quartile managers, which is 190 basis points, gets you to 5.5 per cent, which is a 140 basis point premium over US large-cap equities in our long-term forecast,” explains Sharma.
The above illustrates where RV hedge funds, alone, can be used on both ends of the stock/bond frontier as market beta dampens.
Alpha could mean revert over next decade
While the last five years have been undeniably challenging for hedge funds, from an alpha generation perspective, the LTCMA report paints a different picture when one looks at the previous decade as a whole. It was, in many respects, a decade of two halves. Although the alpha trend line has fallen consistently, alpha levels stayed above 1.5 per cent up until 2015, before sliding into negative territory in 2019.
The upshot to this is that even though the alpha trend line has fallen since the GFC it is still positive, generating an average of 1.50 per cent for the decade. Taken in this context, it paints a different picture of hedge funds’ ability to generate alpha. Despite prevailing headwinds caused by central bank intervention, hedge funds still produced a net positive return.
Looking ahead to the next 10 to 15 years, the LTCMA forecast is upbeat for the asset class, and suggests a modest reversion to the mean long-term alpha estimate, if, as the report suggests, operating conditions do indeed improve for hedge funds.
“As base rates normalise over the next 10 to 15 years, this will also be a positive contributor to hedge fund returns and create better conditions for active managers,” states Sharma.
Median equity long-bias managers are forecast to return 3.4 per cent in 2021, of which the beta return is expected to be 2.1 per cent and the alpha return 1.30 per cent. With RV managers, the opposite is true where the beta return is expected to be 1.1 per cent and the alpha return 2.5 per cent.
This is encouraging for RV managers who aim to ramp up their fundraising activities next year.
“We think monetary policy and a small cohort of technology stocks have compressed dispersion and volatility, which has led to more muted hedge fund returns over the last five years. That dynamic is challenging. The confluence of monetary and fiscal policy, and fundamentals having a bigger role to play, are going to be tailwinds for alpha generation,” adds Sharma.
Two recently emerging dynamics, as seen by JP Morgan Asset Management’s hedge fund assumptions team, are also likely to have some positive impact on alpha trends: increased sector specialisation at one end of the spectrum and the increased resources, capabilities and multi-expertise that come with the mega-size multi-strategy funds at the other end.
“We see longer term a bifurcation with smaller sector specialists on one end and larger multi-strategy shops on the other end.
“Another net positive is the integration of ESG policies into hedge fund strategies; that is, building portfolios more thematically, and orienting stock picking, around ESG themes. That could be another tailwind for alpha,” Sharma suggests.
He concludes by saying that hedge funds, over the next decade, will have a very important role in investors’ multi-asset class portfolios as a hybrid asset class delivering diversification and alpha:
“Manager selection will remain key to success here. More broadly, we think return compression in traditional assets will cause investors to look for a wider opportunity set within the alternatives space.”