Funds that hedge can give portfolios an edge

One can look at the hedge fund universe similar to how a nutritionist might look at types of food: Some are good in relatively large quantities, some are desirable only in moderation, some look good but are actually bad, and some used to be good but are now past the best-if-used-by date. Be careful what you buy.

Origin and classification

Hedge funds have existed for more than 70 years, with Alfred Winslow Jones widely credited with creating the first long/short equity fund in the late 1940s. In subsequent decades, the hedge fund industry grew, first slowly and then quickly, especially in the early 2000s. But this growth accompanied increasing confusion as to what a hedge fund is.

Similar to most other hedge fund researchers and investors, we bucket hedge funds into four main strategies: Equity Hedge, Event Driven, Relative Value, and Tactical Trading (also known as Global Macro). Analysis of hedge funds over many years has led to the following conclusions:

• Equity Hedge (EH) and Event Driven (ED) strategies tend to have positive net exposures to equities and/or credit. As a result, a skilled manager will generate a total return that includes alpha from security selection as well as beta from market exposure.
• Relative Value (RV) and Tactical Trading (TT) strategies tend to have relatively low net exposures to traditional assets. Returns for the best managers are therefore driven mostly by security/trade selection and significantly less by market exposure.

How to choose hedge funds and construct portfolios

When analyzing individual hedge funds, we believe best-in-class asset managers will assess the following:

• Capability of the investment team and operations teams
• Robustness of the investment process to generate returns now and in the future
• Ability to measure risk and, importantly, the willingness and know-how to manage it appropriately

When building a specific portfolio of hedge funds, we believe asset managers should consider:

• Objectives and constraints of a specific fund or mandate
• Possible evolution of the market environment, which informs the types and magnitudes of risks they are willing to take
• Relative attractiveness of specific strategies over the next 12-24 months

We can't emphasize enough the importance of manager selection, because not all hedge funds are created equal. Think of it this way: When looking at short-term weather forecasts, we generally expect a tight forecast range. If, for example, one weather forecaster predicts a high of 80° for tomorrow, another might predict a high of 78°. It's unlikely that yet another would predict a high of either 65° or 95°. This is because weather forecasters have the same objectives (accurate weather prediction), they use the same underlying data (from the National Weather Service), and they use similar models.

By contrast, any two randomly selected hedge funds won't share the same objectives, they will likely rely on different data sources, and they often have dissimilar models. As an illustration of the heterogeneity of hedge fund strategies, consider the following chart that show dispersion of returns in the first half of 2020.

6 Month HFRI Return Dispersion (Jan - Jun 2020)

Source: Underlying return data from Hedge Fund Research, Inc.; calculations by Russell Investments

It is true that the first half of 2020 was atypical, and yet we usually see a high level of dispersion in hedge-fund returns over any time period. To be sure, a large return in the first half of 2020 didn't necessarily demonstrate a great investment process, and a large negative return didn't necessarily demonstrate a broken one. Nevertheless, our experience informs us that, over time, the best hedge funds will usually outperform mediocre ones on a risk-adjusted basis, and they will usually capture significantly more upside volatility than downside volatility.

The best hedge funds live up to their time-worn names and actually hedge, while generating attractive absolute returns over time. Combining hedge funds with different return drivers can generate attractive return streams while adding useful diversification to a total portfolio. In other words, funds that hedge give portfolios an edge. This is most evident in major market downturns.

A COVID-19 case study

From an asset price perspective, the first half of 2020 was A Tale of Two Quarters. In the first quarter—the worst of times—a novel coronavirus crept up to and then exploded on the world stage. Equity and credit markets went into freefall. But then sentiment reversed course, and we entered the second quarter—the best of times. By the end of the first half, global equities were down compared to the end of 2019, but not abysmally. Credit spreads, thought wider, were substantially tighter than March's very wide levels.

How did our hedge fund managers navigate this environment? Reasonably well, in our view. As an example, within one of our commingled fund-of-hedge funds (Fund Q), which invests in 18 underlying funds, four were up in the first quarter. Most of those that weren't up still protected capital at least as well as expected. We were very pleased that 14 underlying funds ended the second quarter up on a year-to-date basis, and we were also pleased that the Fund Q was up as well.

As discussed above, EH and ED strategies tend to have higher market exposures (or market betas) than RV and TT strategies. As a result, we were not surprised that in a strong risk-off environment such as 1Q20, Fund quarter EH and ED strategies underperformed the RV and TT strategies. We were also not surprised that EH and ED outperformed RV and TT in the risk-on environment of 2Q20.

Median performance of hedge fund strategies vs. equities and credit

Source: Russell Investments

Across the full 1H20 period, the median strategy across both EH/ED and RV/TT handily outpaced the MSCI ACWI and the Bloomberg Global High Yield Indexes. This illustrates the benefits of true hedge funds: They can truncate losses in severe down markets, and then rebound to capturing significant market upside. Hedge funds that do this across multiple cycles will likely produce good absolute long-term performance combined with attractive Sharpe ratios.

The bottom line

We prefer hedge funds that can deliver excess return, manage risks well, and diversify traditional risk exposures. By those measures, hedge funds that we invest in met our expectations in a very turbulent first half of 2020. We don't have a good crystal ball to know how markets will move over the next 12 months, but we do believe that hedge funds can fill an important role in a portfolio.