The financial media would have you believe that hedge fund investors will soon pull their money from these overpriced vehicles that have underperformed the S&P 500 index in recent years.
Yet in February, hedge funds enjoyed their strongest monthly inflows since before the 2008 financial crisis, the majority coming from sophisticated institutional investors.
In a recent paper, Donald Steinbrugge, founder and managing partner of Agecroft Partners, a hedge fund consulting and marketing firm, analyzed the disconnect between media reports and investors’ attitude and behavior.
Steinbrugge wrote that institutional investors don’t use the S&P 500 as a benchmark for the performance of their diversified multistrategy hedge funds because hedge funds are not an investment asset class. “They are a legal structure that represents a highly divergent group of strategies, many of which have little to no equity exposure.”
Comparing a hedge fund portfolio consisting of CTAs, global macro, structured credit, market-neutral equity, distressed debt, event driven investing, volatility strategies and long/short credit managers with the S&P 500 makes as little sense as comparing an average mutual fund with the index, he said.
So, why are institutions increasing their hedge fund allocation and how are they gauging performance?
Typically, pension funds meet annually to determine the optimal asset allocation with the highest expected return for a given level of volatility going forward.
Steinbrugge points out that a diversified hedge fund portfolio has a low correlation to long-only benchmarks, which can improve portfolio diversification and potentially provide downside protection during a market selloff.
A diversified hedge fund allocation can also enhance the forward-looking return assumptions of the overall portfolio.
According to Steinbrugge, most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds, which compares favorably with core fixed income, where the expected return is only 2.5% to 3%.
“As long as the expected return is higher for hedge funds than fixed income, we will continue to see money shift from fixed income to hedge funds.”
Since most of the new flows into hedge funds are coming from fixed income and not equity portfolios, many institutional investors in the short term will be happy if their hedge fund portfolio outperforms their fixed income portfolio, validating the decision they made, he said.
Others will be happy if their hedge funds outperform the forward-looking return assumption they used in their asset allocations model.
In both cases, Steinbrugge said, they were happy in 2013, because Barclays Capital Aggregate Bond Index was down approximately 2%, while the average hedge fund was up 7% to 12% depending on the index used.
Steinbrugge laid out some alternative ways to evaluate a diversified hedge fund portfolio, noting that “it is important to remember that, since most hedge funds hedge a portion of their market exposure, all benchmarks are more accurate comparisons over longer time periods.” Most investors want to get the highest return for a given level of risk, and the most common way to measure this is by calculating the portfolio’s Sharpe ratio. Steinbrugge said this was “the fairest way to compare the performance of a portfolio because it equalizes the return generated based on the level of risk taken.”
A customized blend of global stock and bond market indices is another way to measure performance, he said, because some investors’ hedge fund portfolios allocate only to equity-related strategies, while others may have no equity market exposure. “Investors should consider using a blend of various long-only indices that most closely match their underlying portfolio.”
For their part, the media want a simple benchmark they can use to report monthly hedge fund performance. Steinbrugge suggested that they switch to a 60% blend of the MSCI All Country World equity Index and 40% of the Barcap Global Aggregate Bond Index.
He freely admitted that blending the two indices as a benchmark for the hedge fund sector was flawed. However, he said, “it is simple and would be an improvement over just using the S&P 500. The 60–40 split is also the approximate asset allocation pension funds used before diversifying into alternatives.”
Related on ThinkAdvisor:
- Are Hedge Funds Too Complex for the 401(k) Market?
- Jonathan Hoenig: Capitalist Pig, Ayn Rand Fan, Highly Successful Manager