Liquid Alternatives: More Than Hedge Funds

By Rob Arnott

JUNE 2008 Read Time: 10 min

Hedge funds have gone mainstream. Once the exclusive enclave of the mega wealthy and the most sophisticated endowments, these vehicles are now widely used by institutional pensions, midsized foundations, and registered investment advisors. The promise of absolute returns, regardless of stock market conditions, has unquestionably placed hedge fund allocations at the top of many investors’ “to-do” lists. Hedge funds, however, are expensive, illiquid because of lock-up periods, and opaque because they do not reveal their composition or benchmarks. In this issue, we report that investors can earn strong risk-adjusted results similar to those of hedge funds by widening the opportunity set beyond conventional stocks and bonds to include liquid alternative asset classes.

Over the past decade, hedge fund assets have grown dramatically. Industry consultant Hedge Fund Research (HFR) estimates that 10,000 hedge funds and hedge funds of funds (HFOFs) managed $1.8 trillion at the end of 2007.1  The number of funds in 2007 was roughly three times what it was at the end of 1999, and the amount of assets, four times what was reported for 1999. This impressive growth was fueled largely by institutional investor demand for diversification and absolute returns. Free from the prospectuses, guidelines, and regulations that mutual funds and traditional managers must contend with, hedge funds can use derivatives, lever the portfolio, and “short” securities in virtually any market. With these tools, they can provide absolute returns—for a price.

Hedge funds advertise that the steady and uncorrelated returns they can provide are attributable to alpha (or investment manager skill). On that basis, they collect significant fees from their investors. A typical fee is 2% of assets plus 20% of the fund’s net profits. If the investor uses a HFOF to diversify exposure among funds or fund styles (a seemingly prudent course in light of the highly publicized “blow-ups” that have occurred in the hedge fund space), the investor will pay an additional fee—often 1.5% of assets and 10% of net profits. Cumulatively, these fees take a significant bite out of what the fund passes on to the investor. As Table 1 shows, we estimate that the underlying hedge funds in a typical HFOF would have to return 15% to provide a net 8.0% to the end HFOF investor—that’s a cumulative fee drag of 7.0%! Yikes!

Suppose we approach absolute returns from a different perspective. Let’s pretend hedge funds, their leverage, and their shorting don’t exist. How would an investor achieve absolute returns? The term “absolute return” implies no losses, so we would naturally wish to reduce our risk—or, in other words, not put all our eggs in the same basket. Harry Markowitz quantified how using many baskets (in this case, asset classes) lowers price volatility and, consequently, the likelihood of loss for an investor. To ensure that the investor achieves the maximum benefit from using the “tool kit” of many asset classes, each asset class should have some unique drivers of performance. For example, commodity futures returns may rely on global supply and demand of raw goods while U.S. Treasury Inflation Protected Securities (TIPS) can depend on inflations expectations and the level of real interest rates.

Research Affiliates is an advocate of this “expanded tool kit” approach. Furthermore, in our view, the unique categories don’t have to be “merger” or “convertible arbitrage.” They can be any of a wide range of alternative investment categories. TIPS, emerging market bonds, unhedged nondomestic bonds, commodity futures, REITs, high-yield bonds, international stocks—all fall outside the traditional limited diversification of 60% domestic stocks and 40% investment-grade bonds. Not only do untraditional asset classes have unique performance aspects, but they also have widely published indexes that reflect their results. Most also, therefore, have index funds or exchange traded funds that track the asset’s performance (and, in many cases, have reasonably priced actively managed mutual funds with strong track records).

We combined these alternative asset class indexes equally into an index that we call the “Diversified Asset Portfolio,”2 and we compare its performance with that of a commonly used HFOF index3 and that of the traditional 60% equity/40% bond mix in Table 2.

As you can see, the Diversified Asset Portfolio outstripped all the other combinations. It achieved an annualized 8.0% return with a modest 5.1% standard deviation, resulting in an attractive Sharpe ratio of 0.86 over the 10-plus year study horizon.4 Meanwhile, the HFRI FOF Composite Index produced only 6.4% annually and with a higher standard deviation to post a Sharpe ratio of 0.38. In other words, the Diversified Asset Portfolio posted twice the risk-adjusted return of hedge fund of funds.

When we limited the comparison to bad times for investors, so we could focus on the absolute return theme, we found that the worst calendar year for the Diversified Asset Portfolio (2001) provided a return of –1.2% versus a return for the worst year for hedge funds of funds (1998) of –5.1%.

Note, however, that either the Diversified Asset Portfolio or the HFRI FOF Composite Index gave investors higher returns and less risk than the conventional 60%/40% mix.

To be sure, a dedicated hedge fund allocation certainly has a place in many portfolios. The sizable fee drag and mediocre results of hedge funds, however, suggest that most investors will be better served by broadening their exposure to liquid asset classes before wandering down the hedge fund path.

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1. “Hedge funds end 2007 in positive ground–HFR,” Reuters UK, January 8, 2008.
2. The Diversified Asset Portfolio is an equally weighted portfolio (10% each) of commodities (represented by the Dow Jones AIG Commodity Index), REITs (represented by the Wilshire REIT Index), emerging market bonds (represented by the JP Morgan Emerging Markets Bond Index Global), TIPS (represented by the Lehman U.S. TIPS Index), high-yield bonds (represented by the Merrill Lynch High Yield Master II Index), long-term U.S. government bonds (represented by the Lehman Brothers Long-Term Government Index), unhedged non-U.S. bonds (represented by the JP Morgan GBI ex-US Unhedged Index), international stocks (represented by the MSCI EAFE Index), and U.S. stocks (represented by the S&P 500 Stock Index. U.S. investment-grade bonds are represented by the Lehman (LB) Aggregate Bond Index.
3. We are using the HFRI fund-of-funds benchmark because it reflects the results experienced with live money better than the HFRI single hedge fund indices, which are subject to selection, survivorship, and backfill biases. For more discussion of this issue, see Ennis and Sebastian (“A Critical Look at the Case for Hedge Funds,” Journal of Portfolio Management, 2003) and Fung and Hsieh (“Hedge-Fund Benchmarks: Information Content and Biases,” Financial Analysts Journal, January
/February 2002).
4. The time horizon covers the common period in which the selected indices reported performance data. The governing class for the start date is the Lehman U.S. TIPS Index, which started in 1997 with the launch of TIPS by the U.S. Treasury.