Hedge funds: putting asymmetry to the test

Key takeaways

• Diversification through asset allocation may not be enough
• Time sensitivity and complexity may justify outsourcing to hedge funds
• Hedge funds can potentially help asymmetric return profiles during down markets.

In the March issue of Market Perspectives, we highlighted that although having a well-diversified portfolio might be necessary to manage portfolio volatility, it may not be sufficient in avoiding the least probable, extreme, tail risk.

With returns tending to mirror a bell curve distribution but with fatter tails, the left tail corresponds to heavier losses. So, eradicating, or alleviating, the pressures that a left tail scenario could impose on a portfolio, should be a key objective for investors.

While using options (that is, buying puts) eliminates the left tail, it does so at a cost. Dynamic hedging through futures contracts may be less expensive than options, but requires an embedded framework: constant monitoring/adjusting of the portfolio and can also be difficult when timing market corrections.

Outsourcing the management of tail risks and considering investing in hedge funds with systematic asymmetric returns may be worth considering. Successful strategies will need to show that during down markets, the strategy can outperform the market.

Looking at the average quarterly returns during down markets for the MSCI USA net total return index since 2000 and comparing it against hedge fund indices, reveals that the negative return on hedge fund indices was significantly better than seen with equities.

The second hurdle facing hedge funds is achieving an asymmetric return profile – protecting investors’ wealth during down markets while participating in up markets.

Splitting the data into its worst, medium and best average monthly returns for the MSCI USA net total return index and reviewing it against each hedge fund strategy shows us that hedge funds go some way to providing asymmetric returns, even at an index level (see chart).

Overall, the data suggests that hedge funds provide protection for down markets without sacrificing significantly on upside returns.

In fact, the key takeaway is that – at the asset allocation level – hedge funds have improved portfolio returns historically by up to 30-40 basis points for a given level of risk.

Hedge funds can offer diversification benefits and act as portfolio stabilisers, even over the long term – and clearly, this suggests that hedge funds may prove an important element in the optimal asset allocation mosaic.

With volatile equity markets and rising yields pressuring equity risk premiums, hedge funds could be poised to take portfolios from effective diversification to asymmetric-return providers: limiting losses in down markets while participating in gains when markets are rising.

In the March issue of Market Perspectives, we highlighted that although having a well-diversified portfolio might be necessary to manage portfolio volatility, it may not be sufficient in avoiding the least probable, extreme, tail risk. That is, tail risk that lies towards the edges of so-called bell curve distributions of investment returns.

Hedging the left tail

With returns tending to mirror a bell curve distribution but with fatter tails, the left tail, although less probable, corresponds to heavy losses that tend to be greater in frequency, duration and magnitude. Given this, it could be argued that eradicating, or alleviating, the pressures of a left tail scenario could impose on a portfolio, should be a key objective for investors.

While using options (that is, buying puts) eliminates the left tail, it does so at a cost. Dynamic hedging through futures contracts may be less expensive than options, but requires an embedded framework: constant monitoring/adjusting of the portfolio and can also be difficult with regards to timing market corrections.

However, outsourcing the management of tail risks and considering investing in hedge funds with systematic asymmetric returns could be worth considering. For such a strategy to be successful, the first hurdle it must pass is to show that during down markets, the strategy can outperform the market.

Limiting down-market losses with hedge funds

Looking at the average quarterly returns during down markets for the MSCI USA net total return index and comparing it against hedge fund indices, reveals that the negative return on hedge fund indices was significantly better than seen with equities (see table).

Furthermore, during the six worst down markets since 2000, low beta strategies such as market-neutral have proven their worth in limiting losses and, in some cases, earning a positive return (see chart).

Deliberately asymmetric

The second hurdle facing hedge funds is achieving an asymmetric return profile. In other words, protecting investors’ wealth during down markets and still participating in the up markets.

Splitting the data into its worst, medium and best average monthly returns for the MSCI USA net total return index and reviewing it against each hedge fund strategy shows us that hedge funds go some way to providing asymmetric returns, even at an index level (see chart).

Overall, the data suggests that hedge funds provide protection for down markets without sacrificing significantly on upside returns.

While some low beta strategies, such as the equity hedge total index, were less effective in protecting portfolio valuations during down markets, it is worth noting that hedge funds differ greatly by strategy and within strategies. Each fund tends to be quite heterogeneous. As such, this suggests that investors may be well-served by adding hedge funds to a portfolio while also actively selecting managers with robust processes and proven investment methodologies in low-beta strategies.

Hedge funds for the long run

To understand the role hedge funds can play in a multi- asset class portfolio over the long term, we consider an investment opportunity set comprising core asset classes and hedge funds. In particular, we look at the “efficient frontier” for asset mixes consisting of US equities, US government bonds, and the HFRI Fund Weighted Composite Index (a hedge fund benchmark).

The optimisation engine is based on our new strategic asset allocation framework, which accounts for compounding effects and tail risk. To examine the impact that hedge funds have had on optimal asset allocation policy, we estimate the optimisation input parameters using the last 20 years of data.

The key takeaway is that – at the asset allocation level – hedge funds have improved portfolio returns historically up to 30-40 basis points for a given level of risk. Alternatively, adding hedge funds to equities and government bonds has reduced portfolio volatility by 1-3% and expected shortfall by 1-6%, depending on the efficient frontier segment. The combined effect of return enhancement and risk reduction implies improved portfolio efficiency (see chart).

Portfolio diversifier and stabiliser

The efficient frontier (see chart below) example illustrates how hedge funds can offer diversification benefits and act as portfolio stabilisers, even over the long term. Clearly, this suggests that hedge funds represent an important element in the optimal asset allocation mosaic.