What’s the point of hedge funds?

The proper role of alternatives in a portfolio

By: Johann Colloredo-Mansfeld & Dan Rasmussen

The last decade could not have been a better time to bet that a long S&P 500 index fund would outperform a basket of top hedge funds. As passive investing has increased attention on fees and as private equity has captured the hearts of allocators, hedge funds have become increasingly unloved and unpopular.

But we have never steered from controversy—or from taking contrarian positions. So today, we offer a column in defense of hedge funds. Not hedge funds perhaps as they are, but as they could or should be. Here's how an ideal hedge fund could perform in an ideal portfolio.

We noted in our piece A Flight from Safety that hedge funds were never intended as a replacement for long-only equity allocations but rather as a substitute for fixed income in a portfolio. Yale and Cambridge Associates and the other originators of the endowment model had seen that stock and bond returns could be highly correlated—in a negative way—in the inflationary 1970s, and they hoped that substituting hedge funds for bonds could provide meaningful diversification to the portfolio.

We think this is a rather good idea: investors would likely benefit from paying high fees for products that provide returns when traditional stocks and bonds do poorly. And since stocks do poorly when GDP is falling and bonds do poorly when inflation is rising (as we showed in our paper on countercyclical investing), hedge funds might ideally focus on generating alpha in periods when GDP is falling and/or inflation is rising.

How do the broad hedge fund indices live up to this ideal vision of strategies that diversify investors against falling growth and rising inflation? To answer this, we looked at how common hedge fund strategies tracked by HFRI performed across business cycle stages historically. Below, we compare annualized real returns for different hedge fund indices and a 60/40 portfolio across the four quadrants of the business cycle defined ex-post by the change in real GDP growth and inflation. The data is since 2008, the earliest available returns data for hedge funds.

Figure 1: Annualized Real Returns by Strategy and Economic Quadrant (2008–2020)

Source: Hedge Fund Research, S&P Capital IQ, FRED. Computed quarterly.

The event-driven, relative value, and equity hedge funds all have historically performed strongly during periods of rising growth (quadrants 1 and 2). But these are the periods when stocks do best, not the periods when investors need diversifying assets. Fixed-income hedge funds tend to exhibit relative outperformance during periods of falling growth (quadrants 3 and 4) but struggle to outpace the 60/40 portfolio, even at a time when stock and bond portfolios are doing relatively poorly.

These hedge fund indices, with the exception of fixed-income funds, appear to suffer a similar problem: returns are pro-cyclical. Most hedge funds tend to do well during economic recoveries and expansions but subsequently underperform during other stages of the business cycle. A regression of monthly returns of these indices against the returns of the S&P 500, 10-year Treasurys, and commodities reveals why. Figure 2 shows the regression coefficients, intercept, and R-squared values for each hedge fund index. Each strategy has a positive loading on the S&P500 and commodities (we use the GSCI commodity index, which is heavily weighted toward oil), and a negative loading on Treasurys. Macro hedge funds stand as an exception to this general observation.

Figure 2: Regression Coefficients, Intercepts, and R2 Values by Hedge Fund Strategy

Source: Hedge Fund Research, S&P Capital IQ, FRED

In other words, the returns of most hedge funds appear to be highly correlated with equity risk and negatively correlated with Treasurys.

What would hedge funds have to own to perform well in Quadrants 3 and 4 when traditional stocks and bonds are doing poorly? Below we show annualized quarterly returns by asset class and quadrants.

Figure 3: Annualized Real Returns by Quadrant (1990–2020)

Source: Capital IQ, Bloomberg, Ken French Data Library, Verdad. Computed quarterly.

Historically, commodities have been the best performing asset in quadrant 3, when inflationary pressures are rising as the economy slows down. On the flipside, fixed income has been a top performer in quadrant 4, when growth and inflation are both falling, which is typical of recessions. Despite these insights, investors don’t seem to hold enough of these diversifying assets, likely because the relative returns of these assets across the full cycle are much worse than equities.

So hedge fund managers, whose goal is, after all, producing the highest long-term returns, tend to gravitate toward the highest performing assets, thus reducing the diversifying benefits that drew investors to allocate to alternatives in the first place.

In an ideal world, hedge funds would have good judgment about when to increase allocations to these diversifying assets. Funds would hold equity-biased portfolios in quadrant 1 and quadrant 2 and switching into diversifiers in quadrants 3 and 4. In practice, however, this proves to be very difficult. While the above numbers were computed using perfect hindsight, estimating the business cycle stage and timing such a switch can be tricky.

That said, as we have shown in Countercyclical Investing and The Best Macro Indicator, tricky does not mean impossible. The level and trend of the high-yield spread can help predict the direction of the business cycle and help investors shift allocations to achieve the desired diversifying effect in quadrants 3 and 4. To illustrate this, we have constructed a simple countercyclical strategy comprised of the assets in the above figure. The strategy would overweight equities when the high-yield spread estimates the business cycle is in quadrants 1 and 2, while increasing allocation to commodities in quadrant 3 or to fixed income in quadrant 4. To account for signal errors, the strategy would allocate a minimum of 5% of the portfolio to each of the six asset classes. Below we compare the returns of this countercyclical strategy to a 60/40 portfolio and the HFRI composite in each quadrant.

Figure 4: Annualized 3M FWD Returns by Strategy and Quadrant (1990–2020)

Source: Verdad

A countercyclical strategy could have improved returns in the second half of the cycle, as well as over the full cycle. It would have matched the performance of the S&P 500 in quadrant 3 while avoiding its crash in quadrant 4. In fact, the strategy would have underperformed the S&P 500 only during quadrant 2, when the equity market is raging. Also, the high-yield spread signal could help investors avoid painful drawdowns and ensure the necessary liquidity to invest when cycles turn and markets are cheap. For reference, the countercyclical strategy has had a 13% max drawdown, compared to 51% for the S&P 500 and 33% for the 60/40 portfolio over the period of our analysis.

Most importantly, a countercyclical strategy could protect investors from fluctuations in corporate risk (see below). When the S&P 500 has a banner month, excess returns of a countercyclical approach tend to underperform an all-equity approach. However, when the S&P 500 is drawing down, excess returns of a countercyclical approach improve substantially and tend to outperform the S&P 500.

Figure 5: Monthly Countercyclical Strategy Excess Returns vs. S&P 500 Real Returns

Source: Verdad

In sum, empirical evidence suggests that most hedge funds do well when the market rewards all investor behavior. But the reason allocators need hedge funds isn’t to do well in bullish equity markets but rather to diversify when stocks and bonds—the core engine of a traditional portfolio—do poorly.