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February 2017

The long the short and the neutral: uncovering hedge funds' functional properties

Long/short and market neutral strategies can play a key role in portfolio construction.



The years since the bursting of the US credit bubble have forced investors to reassess many of the approaches and assumptions they previously held dear.

Developed market sovereign bonds, for example, can no longer be considered reliable or stable sources of income now that some USD9 trillion of these securities offer negative yields. At the same time, equities have experienced fits of volatility with alarming regularity, causing steep peak-to-trough investment losses that have been difficult to recover.

fig. 1 - bonds and stocks can sometimes move in lockstep, making diversification difficult  

Source: Bloomberg; data based on rolling three-month correlation, data covering period 01.01.2008-30.12.2016

And all the while, the correlation between stocks and government bonds – asset classes that rarely moved in lockstep prior to the Great Recession – has tended to spike whenever central banks step up or scale back their monetary stimulus efforts. 

The upshot of all this is that it has become more difficult to diversify the sources of a portfolio’s risk and return simply by combining fixed income and equity assets. Investors have consequently begun to look elsewhere for capital protection and diversification. They are also increasingly keen to access sources of return that lie beyond the reach of long-only equity and bond strategies.

In turn, hedge funds, which do not track a benchmark and are designed to provide a more favourable trade-off between return and volatility, have become a bigger feature of the financial landscape. Indeed, such strategies have seen their assets under management more than double in the past 10 years to some USD3 trillion.The eVestment database for institutional investors and consultants now tracks more than a dozen different hedge fund strategies, including macro, long/short equity, equity market neutral, event-driven and relative value.

Yet having more options can be a mixed blessing.

Although most hedge funds invest in established asset classes such as equity, bonds, loans, commodities and cash, they differ considerably in the extent to which they combine long and short positions, deploy leverage and use derivatives to generate alpha.

They also vary according to the type of market anomaly they seek to exploit. For example, some strategies aim to take advantage of the mis-pricing of securities within companies' capital structures or between instruments, regional markets, and industry sectors through various arbitrage strategies; others focus on predicting company-specific developments such as mergers and acquisitions that have the potential to trigger large moves in individual stock or bond prices.

Because investment approaches can differ greatly from fund to fund, it is perfectly reasonable to expect the return of, say, a long/short equity strategy to contrast with that of a macro strategy or an equity market neutral strategy under the same market conditions.

Faced with such complexity, prospective hedge fund investors naturally struggle to make an informed choice. But there are ways to chart a course through this challenging terrain. One way to do so is to look at the functions these alternative investments can perform within a portfolio.

This commentary aims to shed light on the functional properties of hedge funds.

Specifically, our analysis builds on a growing body of evidence that shows such strategies can broadly play one of two roles in a balanced portfolio.

Some serve as diversifiers. These are strategies whose returns exhibit little or no correlation with those of mainstream asset classes and can therefore alter the risk-return characteristics of an entire portfolio.

Others serve as substitutes, capable of replacing a portion of equity or fixed income investments to improve the overall return-volatility trade-off.


Substitutes vs diversifiers

A feature common to virtually every alternative investment is its ability to materially alter the risk-return profile of all or part of an investor’s portfolio. Of the many hedge fund strategies available, we believe that two stand out as having demonstrated their transformative powers over several market and economic cycles: equity market neutral (EMN) and long/short equity (LSE).

Portfolio diversifiers

As their name suggests, EMN strategies do not depend on market trends to generate their returns. Managers of EMN strategies construct ‘market neutral’ portfolios by holding an equal proportion of long and short positions; they can also use derivatives to reduce their investments’ beta and correlation with the broader market to negligible levels. When executed well, this ensures that investment managers’ security selection skills become the primary source of return.
fig. 2 - market neutral strategies offer protection against capital loss, favourable Risk-adjusted return
Return, indexed, market neutral funds vs global stocks

Source: MSCI, HFR. Returns in US dollar terms, covering period 31.12.1999-30.12.2016

An analysis of the returns2 EMN funds have delivered since 2000 shows such strategies have offered investors a considerable degree of protection from market falls; the correlation of their returns to those of the market has also remained low – 0.0 and 0.3 versus government bonds and global equity respectively – as has the volatility of those returns.
fig. 3 - market neutral strategies can diversify risk 
Balanced portfolio: return, volatility with/without allocation to equity market neutral strategy, 2000-2016

Source: MSCI, Citigroup, HFR. Returns in US dollar terms, monthly rebalancing, balanced portfolio gross of fees; data covering period 31.12.1999-30.12.2016.

Offering a combination of low beta, low correlation and low volatility, EMN can play a clearly-defined role - that of a diversifier of risk and return for a portfolio composed of bonds and stocks. This is shown in Fig. 3. While a typical balanced portfolio would have delivered a risk-adjusted return of 0.38 per year since 2000, allocating just 10 per cent of that capital to a market neutral strategy would have lifted that figure to 0.42, thanks to a considerable reduction in volatility.

Equity substitutes

LSE strategies are designed to deliver returns that are similar in magnitude to – but less volatile than – those of mainstream equity markets. They take both long and short positions in stocks, but tend to remain ‘net long’ with the aim of both generating positive returns when the market rises and of preserving capital when it falls. Put differently, their returns stem partly from a controlled, actively-managed exposure to beta, the return attributable to the market, and partly from alpha, the return that stems from the security selection skills of the investment manager.

In our analysis of the two most recent market cycles (2000-2016), we find that LSE strategies enjoy certain advantages over mainstream global equities.

As Fig. 4 shows, capital losses for LSE funds are much shallower when financial markets fall, while their returns are – on average – less volatile over the long run. During the two major bear markets of the past two decades – January 1999 to September 2002 and October 2007 to February 2009 – LSE funds offered investors a far greater degree of capital protection.

fig.4 - long/short equity strategies offer protection against market falls
Return, indexed, long/short equity vs global stocks, 2000-2016

Source: MSCI, HFR. Returns in US dollar terms, covering period 31.12.1999-30.12.2016. MSCI World Returns are with net dividends re-invested

Because of these attributes, LSE strategies are able to perform a specific function within a diversified portfolio: they can serve as a substitute for some or all of the equity allocation. As Fig. 5 shows, investing in global equities would have secured a return of 3.1 per cent per year in US dollar terms since 2000; the volatility of that return would have amounted to 15.5 per cent per year.

Yet by replacing 10 per cent of this portfolio’s capital with an allocation to a long/short directional strategy, the yearly return increases to 3.3 per cent and the volatility falls to 14.6 per cent. What’s more, the risk-return trade-off improves with every incremental increase in the LSE allocation.

Fig. 5 - an allocation to long/short equity can improve volatility-adjusted return of equity portfolio
Return, volatility, %, of equity portfolio with varying allocation to long/short equity, 2000-2016

Source: MSCI, HFR. Returns in US dollar terms, monthly rebalancing, data covers period 31.12.1999-30.12.2016. MSCI World Returns are with net dividends re-invested

Bond substitutes

When it comes to substitutes for a fixed income allocation, the most conservatively-managed EMN strategies represent a suitable option. That’s because such funds can generate volatility-adjusted returns that are superior to those of government bonds, the typical anchor for a diversified portfolio. What is more, their addition to a government bond allocation can deliver benefits throughout the interest rate cycle. Should low interest rates persist, for instance, adding an EMN investment to a bond allocation can enhance the portfolio's yield. If the opposite occurs and bond yields rise, EMN strategies can provide fixed income investors with a way to mitigate the risk.

Combining diversifiers and substitutes

As LSE and EMN possess different functional qualities, the two strategies can be used together in the same portfolio. To see how, we compared the long-term return of a traditional 60 per cent equities and 40 per cent bonds investment to those of balanced portfolios that included allocations to a combination of LSE and EMN strategies.

The analysis shows that even a small allocation to these types of hedge funds can materially improve the portfolio’s volatility-adusted return. For instance, replacing 10 per cent of the portfolio’s total investments with an allocation to market neutral strategies and substituting 20 per cent of the equity portion with LSE increases the annualised volatility-adjusted return to 0.49 from 0.38.

fIG. 6 - Combining diversifiers and substitutes

Source: MSCI, Citigroup, HFR. Returns in US dollar terms, monthly rebalancing, balanced portfolio gross of fees; data covers period 31.12.1999-30.12.2016


A health warning

While hedge funds can play an important role in a diversified portfolio, their usefulness is inextricably linked to the skills of the investment manager. And as many investors have discovered to their cost, investment professionals are not equally skilled. In fact, the dispersion of returns among individual hedge funds is far higher than that of long-only funds.3

What’s more, as many as 10 per cent of all hedge funds close every year.This illustrates that alternative investments require deeper scrutiny than their traditional, long-only counterparts and highlights the importance of manager selection for hedge funds.

First, investors must establish an understanding of the source of a hedge fund’s returns and its sustainability. This would give a clearer – and hopefully more realistic – view of the magnitude of returns such strategies can generate and the time period over which this might materialise. Finding hedge fund managers who are able to achieve genuine, demonstrable and repeatable performance requires extensive research and skill, as well as careful qualitative and quantitative analysis.

Second, prospective investors should also have a thorough understanding of the risks a hedge fund is exposed to. Correctly assessing sources of risk is perhaps even more important than analysing sources of return. Having a clear view on the amount of leverage a strategy deploys, the liquidity of its underlying investments and the counterparty risks to which it is exposed is essential.

Third, investors must assess the transformative powers of a potential hedge fund investment both against their long-term objectives and through the lens of the existing asset composition of the portfolio. They must then monitor whether the hedge fund investment is fulfilling its asset allocation role.


Concluding remarks: hedge funds and strategic asset allocation

Offering sources of return not readily available in long-only investment strategies, hedge funds have traditionally been viewed as a distinct asset class, one that merits its own separate allocation within a diversified portfolio, as Fig. 7 show.

fig. 7 - hedge funds: Their role in portfolio construction

Source: Pictet Asset Management

But in familiarising themselves with the functions such strategies can perform, investors will see that these alternative investments have a different role to play.

This analysis has shown that hedge funds possess a number of functional properties – they are, in effect, specialised tools that protect capital, control volatility and reduce a portfolio’s sensitivity to shifts in the financial markets.

Hedge funds should be therefore be seen as either as an actively-managed diversifier for an entire portfolio or a substitute for investors’ bond or equity allocation.


Appendix: Pictet Asset Management Total Return Strategies

pictet asset management total return strategies, breakdown
Pictet Asset Management Total Return Strategies