Hedge Fund Data
The (un)balanced portfolio – investors should be considering alternatives to the traditional 60/40 portfolio
Over the last ten years the balanced portfolio (60% equities/40% bonds) has done exceptionally well; the synchronous appreciation of equities and bonds since the financial crisis has been without precedent.
Quantitative easing has spurred equities on; with certain sectors – big tech in particular, breaking records almost daily. While at the same time, the almost unbroken trend of lower interest rates means that for most fixed income investors, generating any meaningful yield from their bond holdings is unlikely – without taking on significant additional risk. This could leave bond investors asking whether the ‘extra juice is worth the squeeze?’
The thesis behind the balanced portfolio was simple: growth via equity exposure and carry from fixed income acting as an embedded put option i.e. the ability to make money or offset equity losses during a market sell-off or economic contraction, as interest rates would often decline causing the price of bonds to appreciate.
Since 1990, this portfolio mix has done just that; during the 1990s, when interest rates were high, bonds contributed 46% to the 166% total return of a 60/40 portfolio over the ten year period. In the 2000s, when overall equity returns generated a meagre 6%, interest rates tumbled and bonds picked up the slack, contributing 31% to the overall return of 37% over the ten year period. During the last decade, however, the returns of the bond part of the portfolio have been muted, adding 11% to the overall return of 93%.
With rock-bottom interest rates and a marked return of volatility to equity markets, it is not difficult to find investors that are scratching their heads and asking ‘what now?’
I believe that for traditional investors who have embraced the balanced portfolio thesis, their challenges may be worse than simply not getting much yield on their bonds. Not only is the 40% bond component providing virtually no yield whatsoever; this asset has actually become in real terms a long duration liability, delivering little to no income and vulnerable to shocks (inflation, credit and interest rate risk).
Historically, the bond component of the balanced portfolio acted as a hedge to the overall portfolio risk, but this hedge now has many characteristics of a liability as opposed to an asset. In reality investors own 60% equity exposure, and in real terms, a lot of potential liabilities. The embedded portfolio hedge has become a new source of risk. As far as 60% equities go, the question I am often asked is ‘where do we go from here?’
I never like to make predictions but I am comfortable with the view that the returns from equities that investors have enjoyed since the financial crisis are less likely to be repeated over the next ten years. And, like bonds, equities are also vulnerable to an inflation shock that would likely result in higher interest rates. Higher rates would not be good news for stocks. As Warren Buffet once quipped “Interest rates are like gravity on stock prices”.
There has been some investor participation in alternatives (credit, private equity, real estate and infrastructure), but these efforts have not always provided the positive diversification benefits investors are seeking. Many of these investments are difficult to price at the best of times and during stable environments the illiquid nature of investments demonstrate price stability which conceals the risks embedded within them. Leverage, cyclicality and default risk, as well as the broad market factors such as liquidity, market beta and credit risk are all often overlooked by investors. The comfort that investors derive from the fact that some of these vehicles are in UCITS structures should be questioned further still. It was not that long ago that many of the UK’s real estate UCITS funds halted withdrawals because of liquidity and mark-to-market concerns.
For many investors, following the balanced portfolio approach has become a version of financial ‘muscle memory’. I believe that investors should re-consider their capital allocations given the important shifts that have taken place in capital markets over the last six months and whilst we find ourselves in 2020, it feels a lot more like 2002.
2002 was the year that institutions started to wake up to hedge funds for the first time. Their traditional portfolios were taking a beating because they were in the midst of the internet-bubble-induced bear market. At the time, hedge funds were performing substantially better than the market; and pension funds, private banks and family offices were being converted to the benefits of this new investment style.
In the 6 years between 2002 and 2008, the hedge fund industry AUM grew from $395bn to $2.3tn. Fund of hedge funds became the vehicle of choice for many because they endeavoured to provide investors with a well-researched and diversified portfolio of managers.
I believe that in today’s market environment, hedge funds provide a strong investment case; not just as a de-risking and diversifying strategy for equity investors, but also for alarmed bond investors.
The graph above illustrates that replacing half of an investor’s bond exposure with hedge funds would have resulted in a 1.3% outperformance per annum. While this might not sound a lot, over 30 years this equates to a difference in total return of nearly 150% of the original investment.
Hedge funds have come a long way since 2002 and the successful ones have become cutting edge investment management firms. These are institutional businesses that attract and retain some of the brightest investment minds, with some engaging data scientists and software engineers. Traditional investment managers are struggling to play catch up to these innovative firms.
The opportunity set for hedge funds is growing. The financial response to COVID-19 has had significant consequences. Central bank independence has fallen by the wayside, deficits have ballooned and a number of structural imbalances within capital markets are being exposed. Globally, markets are heading into an alarmingly deep recession. Hedge funds are arguably best placed to capitalise from the greater volatility in equity, foreign exchange and commodity markets. Global macro funds are particularly well positioned to take advantage of the growing opportunities in global fixed income and currency markets.
However, hedge funds are not a homogenous group. There is only a (very) small subset of this large universe that Aurum believes are able to generate sustainable, uncorrelated returns. Certain specific strategies and investment styles are likely to deliver better risk adjusted returns over the evolving market cycle. The selection process is not trivial.
Developing and managing hedge fund solutions has been Aurum’s sole focus for over 26 years. The knowledge gained over this time has underpinned Aurum’s belief that an effective hedge fund allocation should enhance long-term performance and substantially limit the downside risk of a portfolio. The right allocation provides diversification and capital preservation with low beta and low correlation to traditional markets.
Relying on conventional approaches to portfolio management, like the balanced portfolio, are unlikely to meet risk and return expectations given the structural fatigue of these traditional approaches. Investors should be considering whether now is the time to take another look at hedge funds to help achieve their long term investment goals.
For the purpose of this article, we have modelled the balanced portfolio using the MSCI World Equity Index and the Bloomberg Barclays Global Aggregate Bond Index, rebalancing the portfolio annually. Source: Bloomberg
This Post represents the views of the author and their own economic research and analysis. These views do not necessarily reflect the views of Aurum Fund Management Ltd. This Post does not constitute an offer to sell or a solicitation of an offer to buy or an endorsement of any interest in an Aurum Fund or any other fund, or an endorsement for any particular trade, trading strategy or market.
This Post is directed at persons having professional experience in matters relating to investments in unregulated collective investment schemes, and should only be used by such persons or investment professionals. Hedge Funds may employ trading methods which risk substantial or complete loss of any amounts invested. The value of your investment and the income you get may go down as well as up. Any performance figures quoted refer to the past and past performance is not a guarantee of future performance or a reliable indicator of future results. Returns may also increase or decrease as a result of currency fluctuations. An investment such as those described in this Post should be regarded as speculative and should not be used as a complete investment programme.
This Post is for informational purposes only and not to be relied upon as investment, legal, tax, or financial advice. Whilst the information contained in this Post (including any expression of opinion or forecast) has been obtained from, or is based on, sources believed by Aurum to be reliable, it is not guaranteed as to its accuracy or completeness. This Post is current only at the date it was first published and may no longer be true or complete when viewed by the reader. This Post is provided without obligation on the part of Aurum and its associated companies and on the understanding that any persons who acting upon it or changes their investment position in reliance on it does so entirely at their own risk. In no event will Aurum or any of its associated companies be liable to any person for any direct, indirect, special or consequential damages arising out of any use or reliance on this Post, even if Aurum is expressly advised of the possibility or likelihood of such damages.
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