By Andrew Beer (pictured), founder and managing member of Dynamic Beta Investments – Almost overnight, allocators started to swap out fixed income exposure for hedge funds. What’s driving this? Two trends: after large and sudden drawdowns in both 2020 and 2021, many allocators simply want out of traditional fixed income; meanwhile, with alpha back, hedge funds appear to have much better return potential with comparable or lower risk.
Let’s start with the first trend. The difficult reality today is that fixed income investors face paltry expected returns with potentially big downside risk.
Take AGG, an ETF that tracks the Barclays Agg, a diversified representation of Treasuries, investment grade bonds and more complicated things like mortgage securities. Per Blackrock, the current average yield to maturity is around 1.4 per cent.
Let’s call this the base case: very simplistically, you put USD100 in AGG today and six plus years later you have around USD109. Less than you used to earn in a savings account, but that notoriously low volatility (3 per cent) can feel nearly as safe, predictable.
One allocator coined a phrase to describe this thinking: “fixed income is the new cash.”
But volatility is misleading: the real concern these days is downside risk. Investors need to walk a tightrope to earn that 1.4 per cent per annum: risk-free rates stay historically low, credit spreads remain razor thin, defaults are non-existent.
As the chart below shows, both rates and credit spreads are at or near historical lows. As a practical matter, as both approach the “lower bound” of zero, return expectations drop and risk rises.
Two recent canaries in the proverbial coal mine underscored this “fat tail” risk. In the first three weeks of March 2020, as the pandemic took hold, Treasury yields plummeted to well below 1 per cent while credit spreads quintupled.
By month end, fortunately, the Fed had launched an unprecedented QE programme and markets recovered much lost ground. But the intra-month drawdowns were too extreme to gloss over. The chart below shows the March 2020 return and intra-month drawdowns of Treasuries, investment grade bonds and high yield.
Both investment grade and high yield bonds suffered intra-month drawdowns of greater than 20 per cent and posted losses that wiped out years of returns. Even long dated Treasuries, which rose during the month, had a 15 per cent drawdown. This was a flock of angry black swans.
Then, during the first quarter of this year, the “too hot” recovery caused an inflation scare and a spike in Treasury yields.
As shown below, longer dated Treasuries lost nearly 15 per cent. Investment grade bonds also lost money – again, the equivalent of 2-3 years of returns – and had a drawdown of around 7 per cent.
High yield bonds fared much better due to higher sensitivity to equities, which rose. For many segments of the bond markets, a normalisation of rates by 300 basis points – not a huge stretch considering the past 20 years – could mean losses of 10-20 per cent and wipe out a decade of returns.
Put another way, more black swans lurk around dark corners of the fixed income world.
Enter hedge funds. A few years ago, hedge funds were a tough sell. Allocators were primarily concerned that a deflationary spiral might cut the legs out from under sky-high equity valuations. On the fixed income front, yields were abysmal, but the taper tantrum of 2013 was ancient history and monetary tightening an unlikely prospect.
Yet the deflationary spiral did not kick in, and as low rates went even lower, both equity and bond prices marched upward. Rather than act as shock absorbers, both sleeves of the proverbial 60/40 portfolio were hitting on all cylinders.
Hedge funds, in the midst of a rough period for alpha generation, had the dubious honour of delivering bond-like performance with equal or higher risk, or less than half the return of equities with half the risk.
Many investors concluded, perhaps rightly, why bother?
Today, the hedge fund renaissance is in full swing. Take the March 2020 period described earlier: like most investors, hedge funds were largely caught off guard by Covid-19 and the hedge funds lost 9 per cent intra-month – not perfect, but very good in the context of both equities and bonds. Yet hedge funds adapted quickly and, as we’ve written elsewhere, anticipated both the economic recovery and value rotation.
They ended the year up high single digits with enough alpha generation to make up for years of struggles. Then many hedge funds, like managed futures, called the inflation scare early and made money as rates jumped. The latter performance increased the appeal of some strategies as “dynamic inflation hedges” – and hence a direct way to mitigate some of the fat tail risks described above.
Which brings us full circle to expected returns. What will hedge funds return over the coming decade? Obviously, no one knows for certain. But 1-2 per cent per annum in fixed income is a very, very low bar. Even during the “lost” years of the 2010s, hedge funds earned 4 per cent a year – after a ton of fees.
Throw in some decent market conditions with alpha generation, and you can easily see 6 per cent a year. Intelligently cut out fees and expenses and even more alpha generation might make its way back to client portfolios.
For allocators, this could mean three to four times the return, with the same or lower risk. Framed this way, the substitution argument may be a no-brainer.
