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 below-average 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 with 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.

Risk Adjusted Returns: The Sharpe Ratio for the HFRI index was also lower than both the balanced portfolios over the period we tracked: 0.12 versus 0.19 for the stock-heavy balanced portfolio and 0.41 for the bond-heavy balanced portfolio.

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.

At Litman Gregory Asset Management, we selectively pursued some hedge funds for some of our larger individual and our institutional clients. Our results varied.

We invested in hedge funds in two ways. Because of very high minimums (most funds have $1 million minimums or more) and our belief that diversification is important, we used two fund of funds. In each case we did intensive due diligence to assess the expertise of the firms we invested with. The funds we invested with came with excellent pedigrees and track records, but, to date, the performance has been somewhat disappointing. Both lost well over 20% in 2008, and overall they have not added value to our portfolios during the time we've owned them (primarily because of the economic events of 2008). 

We also invested in several individual hedge funds in a private fund we run (much of the portfolio is run using our tactical asset allocation strategy). Overall, these investments have been extremely successful. We invested in six funds (one was a specific play on non-agency mortgage securities). One was mildly disappointing and we exited the fund in less than two years. However, the other five have performed beyond our expectations and collectively they materially improved performance on an absolute and risk-adjusted basis and added significant alpha to the portfolio. The success of these funds and our high batting average was supportive of our due diligence capabilities in the alternatives space. Some of the performance characteristics of these funds are shown in Appendix 1.

More recently, we also 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-fund-like strategies. (We wrote about our growing research in this area in our March 2010 investment commentary.) However, the vast majority we have looked at have not been compelling. We recently looked at Morningstar's Multialternative category, which, as mentioned above, 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 significantly 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 researched 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?

Success in raising assets also doesn't reflect performance success. When we examined the record of one particular fund in this category that has been very successful in raising assets, we noted that its performance over the past five years has been strong relative to the HFRI Diversified Fund of Funds Index. Over the past five years (through June) the fund's return exceeded the index by more than 150 basis points. Volatility was lower and the Sharpe Ratio was higher. On this basis, the fund's performance looks impressive. However, using a higher and, in our view, more appropriate benchmark—the 35%/65% stock/bond balanced portfolio—the fund's return lagged by almost 250 basis points per year (3.2% versus 5.6% for the index). Its standard deviation was a tad lower than the index, and, during the November 2007 through February 2009 period, the drawdown was almost identical—negative 17.7% versus negative 17.3% for the index. Its Sharpe Ratio trailed the index by 0.17 versus 0.37. (The conclusions are similar looking at the entire life of the fund—just over six years). So, relative to a more traditionally allocated portfolio, the fund's performance is not particularly impressive. The fund's asset-raising success reflects the demand for alternative investments more than the ability of the fund to provide something different and superior to what investors could have achieved with traditional financial assets.

As we wrote in March 2010 commentary, 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 objectives. 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.

 

 

(c) Litman Gregory

www.advisorintelligence.com