Three reasons to consider hedge funds now

Preparing for a changing context

05 January 2018

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2017 was a good year for the global economy and global equities, and in 2018, we expect equities to make further gains. But shifts in monetary policy, correlations and more broadly, a maturing economic cycle, mean that investors need to adapt to a changing investment context. This will require a combination of a more agile approach to investing, a diversified portfolio, and a discipline to focus on the long-term to avoid common investing pitfalls. Here is why, in this context, hedge funds can help your portfolio.

Hedge funds benefit from rising rates

Monetary policy normalization will remain a focal point for 2018. With global growth expanding at its fastest pace in six years, central bankers will likely continue to view the economy as strong enough to withstand stimulus withdrawal and higher interest rates. However, not all asset classes perform the same under these scenarios. Based on historical data, we find that hedge funds are fairly resilient to rising rates - on an absolute return basis, hedge funds have typically outperformed most other asset classes, with fixed income performing worst of all.

More differentiated markets need more sophisticated strategies

At turning points in monetary policy, markets typically become more responsive to idiosyncratic factors - investors may have noticed the sharp decline in macro and micro correlations over the past few months. With solid growth but changing macro trends and rising interest rates, movements of securities within and across markets have become less correlated, creating more winners and losers. Investors who have been favoring traditional passive instruments may now be forced to review their allocations and seek active strategies that are more agile and focused on individual company performance. This is the focus of many hedge funds. Their alpha generation typically increases in these periods given the broader set of trading opportunities they can take advantage of.

More challenging times ahead require action now

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria” – Sir John Templeton.

Investors are rarely prepared for a downturn. CIO does not believe that we have entered euphoria territory yet, but ensuring that strategic allocations are ready to navigate more volatile periods should start now. Based on historical data, in every year that the S&P 500 has fallen, hedge funds in aggregate have lost less than the overall market. Some strategies, such as CTAs (commodity trading advisors), even generated some of their best returns during market meltdowns. This capacity to limit losses has also allowed hedge funds to recover faster than equity markets.

2018 is unlikely to be easy for investors and while we do not see cause for alarm, we acknowledge that changing market conditions call for action. We believe hedge funds will play an increasing role in multi-asset class portfolios. Depending on their profile, we advise under-allocated investors to revisit their investment strategy and consider an allocation to hedge funds with a focus on being well-diversified across strategies, managers and regions.

Non-Traditional Assets

Non-traditional asset classes are alternative investments that include hedge funds, private equity, real estate, and managed futures (collectively, alternative investments). Interests of alternative investment funds are sold only to qualifed investors, and only by means of offering documents that include information about the risks, performance and expenses of alternative investment funds, and which clients are urged to read carefully before subscribing and retain. An investment in an alternative investment fund is speculative and involves signifcant risks. Specifcally, these investments (1) are not mutual funds and are not subject to the same regulatory requirements as mutual funds; (2) may have performance that is volatile, and investors may lose all or a substantial amount of their investment; (3) may engage in leverage and other speculative investment practices that may increase the risk of investment loss; (4) are long-term, illiquid investments, there is generally no secondary market for the interests of a fund, and none is expected to develop; (5) interests of alternative investment funds typically will be illiquid and subject to restrictions on transfer; (6) may not be required to provide periodic pricing or valuation information to investors; (7) generally involve complex tax strategies and there may be delays in distributing tax information to investors; (8) are subject to high fees, including management fees and other fees and expenses, all of which will reduce profts.

Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the fnancial ability and willingness to accept them for an extended period of time before making an investment in an alternative investment fund and should consider an alternative investment fund as a supplement to an overall investment program.

In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these strategies:

  • Hedge Fund Risk: There are risks specifcally associated with investing in hedge funds, which may include risks associated with investing in short sales, options, small-cap stocks, 11junk bonds,11 derivatives, distressed securities, non-U.S. securities and illiquid investments.
  • Managed Futures: There are risks specifcally associated with investing in managed futures programs. For example, not all managers
    focus on all strategies at all times, and managed futures strategies may have material directional elements.
  • Real Estate: There are risks specifcally associated with investing in real estate products and real estate investment trusts. They involve risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax, real estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks associated with the ability to qualify for favorable treatment under the federal tax laws.
  • Private Equity: There are risks specifcally associated with investing in private equity. Capital calls can be made on short notice, and the failure to meet capital calls can result in signifcant adverse consequences including, but not limited to, a total loss of investment.
  • Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of the United States should be aware that even for securities denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer’s “home” currency can have unexpected effects on the market value and liquidity of those securities. Those securities may also be affected by other risks (such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.

How have hedge funds performed in past downturns?