When hedge fund indices tumbled in tandem with equities during this year’s historic Q1 sell-off – before sharply rebounding in April with their biggest monthly gain since the 2008 financial crisis – it reignited the debate over alternatives’ role in investment portfolios, and particularly the hedge fund industry’s core objective of outsized gains uncorrelated to broader marker performance.
When hedge fund indices tumbled in tandem with equities during this year’s historic Q1 sell-off – before sharply rebounding in April with their biggest monthly gain since the 2008 financial crisis – it reignited the debate over alternatives’ role in investment portfolios, and particularly the hedge fund industry’s core objective of outsized gains uncorrelated to broader marker performance.
Certain marquee-name managers have built their formidable reputations with stellar returns across a range of environments. But when the coronavirus pandemic upended the global economy earlier this year, with hedge funds turning in less-than-stellar performances, it reamplified that perennial industry bugbear: high fees for mixed returns.
“Hedge funds lost money when the market went down in March, and they all made money when the market went up in April. So what does that tell you? It’s the same old industry,” one long/short equity hedge fund manager observes.
“The whole point of a hedge fund is that they’re supposed to generate returns at different points to the market. But very few of them do.”
The London-based trader – who generated double-digit gains during March’s mayhem – describes his peers’ continued close correlation to broader markets as “extraordinary.”
“They call themselves hedge funds, but actually they’re just expensive beta. If you want beta, then you’re better off buying a passive fund,” he suggests.
Winners and losers
Such sentiment has reverberated across both the manager and investor community for several years, but the recent Covid-19 crisis has thrown up fundamental questions around hedge fund performance, crisis alpha, and portfolio protection.
Before rising almost 5 per cent in April, the HFRI Fund Weighted Composite Index – which tracks the returns of 1,400 single-manager funds globally – lost close to 6 per cent in March, with HFR’s equity-only indices seeing even sharper gyrations.
Some market participants suggest looking beyond the headline index data, and deeper into the more nuanced performance patterns among individual firms and strategies – whether long/short equity, macro, or managed futures – in an industry long defined by winners and losers.
It’s a point recently brought into sharp focus by the contrasting fortunes of two titans of the industry: Alan Howard, whose own personal macro-focused strategy has reportedly risen 100 per cent since the start of 2020, and Sir Michael Hintze, the credit-focused veteran whose flagship fund floundered as markets went haywire.
“There are some funds who made money in March, who also then made money in April; or who lost very little money in March and have done well in April, and are now significantly outperforming their underlying markets year-to-date,” notes Patrick Ghali, managing partner and co-founder at Sussex Partners.
He acknowledges that certain hedge fund strategies have disappointed this year, pointing to certain credit vehicles dependent on liquidity which have suffered “terrible damage” during the coronavirus-driven correction. But he maintains that investors must remain discerning in their hedge fund selection.
“There are also plenty of managers who are up 20, 30, 40 per cent this year and have done extremely well through this crisis,” he says.
As 2020’s midway point nears, hedge fund indices on average have not replicated the kind of eye-watering losses seen in other asset classes, indicating alternatives are broadly doing their job in weathering volatility and providing buffers in portfolios.
Initial performance metrics for May suggest hedge fund portfolios were making money in both up and down markets, according to Cedric Vuignier, head of liquid alternative managed funds at SYZ Asset Management.
“If you take hedge fund indices which have a larger allocation to equity hedge, it is clear that you have a higher correlation to equity indices,” Vuignier says.
“We could say that hedge funds were too correlated in March, but the largest drawdown that we saw was not equity market-related, but rather due to a lack of liquidity in arbitrage and structured credit strategies,” he explains.
“For our portfolios, we are looking for more uncorrelated strategies which will underperform during an equity bull market but will better handle volatile markets.”
Cushioning the blow
As the nascent global economic recovery remains precarious, and managers running various strategies reportedly prepare for a second market shock, crisis protection remains a key priority for investors heading into the second half of 2020.
Advocates for the industry say this year’s turbulence has flagged up the perils of passive investing, potentially accelerating moves towards greater portfolio diversification beyond a traditional equities and bonds mix.
“A lot of the brand name managers, the large well-known hedge fund firms, are reopening again for the first time in years, and people seem happy to pay the fees and to snap up that capacity as quickly as it becomes available,” Ghali says of this burgeoning appetite.
“To just have a traditional 60/40 portfolio, or just be long-only, isn’t a great strategy,” he adds. “It makes sense to start looking at alternative sources of returns. Investors should start looking for inflection point alpha.”
Vuignier, who has seen growing interest over the last 18 months and expects to raise assets further this year, says the current environment bodes well for alpha generation.
“A lack of liquidity has always been the enemy of a few hedge fund strategies. However, as they are less leveraged and more robust than what we saw in previous crisis such as in 2008, they have handled the current crisis a lot better and therefore, they are in an extraordinary position to benefit from the current dislocation,” he explains.
Volatility is likely to be a central feature of markets for the foreseeable future. But by cushioning the blows suffered elsewhere in investor portfolios, hedge funds can prove their value in any potential fresh round of chaos that lies ahead.
Making the case for actively managed strategies measured on their trading prowess, Ghali says: “If you can demonstrate to investors that you can generate returns from non-traditional sources, that’s how you stay relevant.
“Generally, we think this is a really good environment for active managers. It’s not just cushioning the blow – there are plenty of managers that are providing proper alpha, and have shown why you want them in the portfolio.
“Strategy and fund selection will be key going forward. But I don’t think the hedge fund model is broken at all.”
