introduction
Alternative investments accounted for $13 trillion in assets under management (AUM) in 2021, almost double the quantity in 2015. By 2026, this number is anticipated to succeed in greater than $23 trillion. in keeping with Preqin research. These are boom times for enterprise capitalists, private equity (PE) and hedge fund managers.
Although 2022 has not been particularly favorable for enterprise capital, amongst other things, some fund managers are doing higher than others. Why? Because they will refine the valuations of their investments. PE funds don’t have day by day mark-to-market accounting, allowing them to soak up losses over multiple quarters.
The ingenuity of this practice is that although they’re exposed to an identical risk PE returns don’t appear to correlate with stocks. Everything looks great on paper.
Correlations are the hallmark of different investments. Producing uncorrelated returns in a yr when the normal 60/40 stock-bond portfolio has posted double-digit losses is a fast technique to attract investor interest and capital. However, correlations are like icebergs floating within the sea. There’s quite a bit hidden beneath the surface.
So what are the pitfalls of using correlations to pick out alternative strategies?
The alternate champions
To discover, we chosen seven well-known strategies from the hedge fund universe which have attracted billions of dollars from capital allocators. Our data comes from HFRX, whose day by day returns date back to 2003. This nearly 20-year period covers multiple market cycles wherein alternative strategies must have demonstrated their value through diversification advantages.
We calculated the correlations of those hedge fund strategies to traditional asset classes. Three of those strategies – Equity Hedge, Merger Arbitrage and Event-Driven – have S&P 500 correlations above 0.5. Given their similar risk profiles, it might make little sense so as to add these stocks to a stock portfolio.
However, three strategies showed low correlations within the equity market, without high correlations with US investment grade bonds. This suggests they could offer some value for investors.
Hedge fund strategies: correlations to stocks and bonds, 2003 to 2022
Quantifying the advantages of diversification
When given a set of different strategies, a capital allocator should select those who have the bottom correlation to stocks and bonds because they’ve the best diversification potential.
To test this hypothesis, we sorted the seven hedge fund strategies by their average correlation to stocks and bonds and ran simulations wherein each strategy added a 20 percent allocation to a 60/40 stock-bond portfolio after which quarterly was reweighted.
Contrary to expectations, the addition of an alternate allocation didn’t improve Sharpe ratios for the period 2003 to 2022.
Even more odd is that there appears to be no connection between the correlations. For example, merger arbitrage had a better average correlation to stocks and bonds than neutral correlation to the stock market. However, adding the latter to a standard portfolio didn’t end in a significantly higher Sharpe ratio.
60/40 portfolio plus 20% alternative allocation: Sharpe ratios, 2003 to 2022
Next, we calculated the utmost drawdowns for all portfolios. This all happened through the global financial crisis (GFC) in 2009. Both stocks and bonds fell, much like what happened this yr.
Our stock-bond portfolio fell 35%, while our diversified portfolios all fell between 31% and 39%. Such risk reduction just isn’t particularly impressive.
But as with our previous Sharpe ratio evaluation, maximum drawdowns didn’t decrease further when more diversifying alternative strategies were added.
We would expect a linear relationship between decreasing correlations and declines, not less than until the correlations reach zero. If they grow to be too negative, as in a Tail risk strategy, then the diversification advantages deteriorate again. We expect an unhappy smile, but nobody smiles.
So do correlations fail investors of their seek for sensible alternative strategies?
60/40 portfolio plus 20% alternative allocation: Max drawdowns, 2003 to 2022
Fair weather correlations
A partial explanation for our results is that correlations are misleading. Even in the event that they are near zero on average, there can still be periods of high correlation. Unfortunately, correlations often rise precisely when investors demand uncorrelated returns.
Take Merger arbitrage for instance. The strategy is often uncorrelated with stocks, but when stock markets collapse, mergers fail. A portfolio with long positions in acquiring corporations and short positions in acquiring corporations might be constructed in a beta-neutral manner. However, this doesn’t negate the economic risk that can be inherent in stocks.
All of our seven alternative strategies lost money through the global financial crisis between 2008 and 2009. Convertible bond arbitrage lost even greater than stocks. That’s quite a feat provided that the S&P 500 is down 53%.
Hedge fund strategy performance through the global financial crisis (GFC), 2008 and 2009
Why else have alternatives didn’t improve Sharpe ratios and reduce drawdowns? Because truthfully, they’re bad at earning profits. While they generate attractive returns before fees, their net returns to investors have been poor during the last 19 years.
The S&P 500 achieved an annual growth rate of 9.5% from 2003 to 2022, but that just isn’t the precise benchmark for hedge fund strategies. Hitting bonds is a more reasonable goal and has only been achieved through merger arbitrage. And this strategy is simply too tied to stocks to supply significant diversification.
Inflation was around 2% during this era, so CAGRs below that imply negative real returns. Inflation is far higher today, so the targets for these strategies are much further away.
Hedge fund strategy performance: CAGRS and correlations, 2003 to 2022
More thoughts
Correlations alone usually are not enough to discover alternative strategies. A more nuanced approach is required. In particular, investors should measure correlations when stock prices are falling. This eliminates merger arbitrage and other strategies that carry inherent economic risk.
If calculated appropriately, this could show that almost all private asset classes – PE, VC and real estate – carry the identical risk. She subsequently offer only limited diversification advantages. We need higher tools to measure the diversification potential of different strategies.
Of course, this does not change the underlying problem: many strategies not generate positive returns. For example, the typical equity market neutral fund has lost 0.4% annually since 2003.
The arguments for uncorrelated negative returns usually are not sound.
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