Putting the Hedge Back in Hedge Funds

Often seen as the ‘bad boys’ of the financial world, hedge funds can be an especially smart investment in times of market stress

Despite being the financial boogeyman, kicked around by politicians and vilified on television, hedge funds are a smart way to protect hard-won investment gains as well as garner a certain amount of liquidity during periods of market stress. Like now.  But the term “hedge funds” is broad. For instance, this past week Bank of America announced that hedge funds just bought a record amount of equities during the market plunge, yet the next day the Wall Street Journal reported that many hedge-fund managers have stepped aside and are “stockpiling cash.” So which is it?

Probably both, after all, “hedge funds” encase many different strategies. BarclayHedge lists 17 different hedge fund indexes, from equity long/short funds to fixed income to global macro to Healthcare & Biotech and Pac Rim Equities. Commodity trading advisors (CTAs) have their own breakdown, but often are put into the hedge fund or absolute return buckets of institutional investors.

Like other investment funds, performance can vary with strategy. For example, in 2015, the worst performing hedge fund index according to BarclayHedge was distressed securities, down 9.86% for the year. Yet according to Hedge Fund Research, over a 15-year period the strategy returned a compounded average of 7.4%. Then there are merger arbitrage funds, which according to BarclayHedge had the best 2015 average return:  7.88%. Yet according to HFR, its 15-year compounded return was 4.3%.

This analysis also applies to CTAs. Overall, the Barclay CTA index was down -1.25% for 2015, while currency traders were up an average 4.50%. The return of the BTOP50 index, which is an average of the largest CTAs, fell almost 1% in 2015, although this year so far it’s up almost 5%. Again, looking inside the average is key: Aspect Capital, a systematic diversified futures program, ended the year up almost 8% (this after a 32% gain in 2014), whereas another fund, Cantab Capital Partners’ CCP Quant Fund, was down just over 8% in 2015 (although was up 39% in 2014).

The point is: There are many strategies within hedge funds, and picking the right strategies for these times can be essential to protect an investment portfolio.

Lyxor Cross Asset Research, a managed account platform, states in its bi-weekly letter dated Jan.18 that “Hedge funds, which have adopted a defensive stance over the course of the second half of 2015, have been able to navigate the turmoil without major damage." They note that though the Lyxor Hedge Fund Index was down 0.8% as of Jan. 12, 2016, CTAs were up 3.65%, largely due to being long fixed income, long the U.S. dollar and short commodities, as well as having deleveraged equity positions in early January.

So should investors jump into commodity funds? Maybe. Lyxor concludes “Going forward, CTAs appear as the best hedge against additional nasty market developments. We believe that the market concerns are somewhat exaggerated but the momentum and sentiment is so negative amongst the market participants that it seems too early to lean against the wind. We stick to our recommended allocation, which involves a preference for hedge funds with a relative value approach and limited market directionality.”

Some of the above views are echoed by Mihir Meswani, director and portfolio manager of the U.S. Hedge Fund Advisory team of DB Asset Management. He says on the highest level “we are heavy global macro,” based on the central bank divergences, i.e.  U.S. rates rising while other major global rates are down. The theme, he says, is a stronger U.S. dollar and higher interest rates. He adds that they also prefer Europe over the U.S. in terms of developed economies because they see a greater “level of inefficiency” in Europe than in the United States, especially as Europe is now going through what the U.S. did several years ago by cutting interest rates and going through quantitative easing.

Another major theme is within the yield curve, which they see flattening with 2- to 10-year yields, therefore they see strength in relative value trades. By employing the right mix of hedge funds, DB Asset has been able to take advantage of these trends without worrying about the recent equity events. “We don’t have equity volatility in our portfolio,” he says.

DB tactically works with hedge fund investments. CTAs are doing well now because the “trends are more pronounced and have longer duration,” he says. However, with hedge funds, they are bullish on equity market neutral strategies, which he says do well in markets with larger dispersion. For example, last year a manager who picked a narrow band of stocks such as Google or Facebook did well, but now that isn’t the case.

He says in the alternatives universe, it is not “one size fits all.” There are selections in hedge funds such as market neutral that might fit better in the equity bucket of a company. He also believes a combination of hedge fund strategies is the best way to take advantage of the asset class and market.

Liquidity also is key. Hedge funds (minus CTAs) and limited partnerships typically have a year-plus lockup period. Like Lyxor, DB operates a managed account platform that allows investment in multiple hedge and commodity fund managers. For the institutional investor, these types of platforms allow access to a broader selection of managers for a smaller minimum investment and without the hassle of lockups. Thus investors have options during times of stress to take advantage of both sides of the market, as well as hedging the overall portfolio.

--- Check out Showtime’s ‘Billions’: Ruthless Fund Manager vs. Star Prosecutor via Andrew Ross Sorkin on ThinkAdvisor.

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