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A new era for investing: Is now the time for hedge funds?

Investors are turning their attention to alternative asset classes.

“The four most dangerous words in investing,” the famous investor Sir John Templeton once said, “are ‘this time it’s different’.”

 Again and again, investors who have assumed that things were different at any one point in time and changed their strategy accordingly have paid the price, according to Robin Powell (pictured), editorial consultant to private investment firm Sparrows Capital, writing in our sister publication, Portfolio Adviser.

The obvious example is active investing. There’ve been constant assertions over the years that active was about to make a comeback; but investors who invested in equity index funds, and stuck with it, have outperformed most active investors.

Those who tilted their portfolios towards the risk premia identified by the likes of Fama and French — principally size, value, quality, profitability, momentum and low-volatility — have done even better over the long term.

Despite being a staunch advocate of disciplined, low-cost, systematic investing, let’s play devil’s advocate for a moment.

What if the situation we find ourselves in today really is different? What if systematic factor investing is no longer optimal in the investing environment we face today?  And if that is the case, should investors now be looking, as many are suggesting, to alternative asset classes such as hedge funds?

We’re in a new era

In answer to the first question, there are two respects in which we genuinely are in a new era. Firstly, investment returns in the future are likely to be lower than they have been in the past. This is down to the gradual re-rating of equities over the last century and reflects, at least in part, reduced investment risk.

Investing is essentially less risky than it was decades ago. Although the financial markets have been treading water for the last two years, recent decades have seen ever-increasing valuations and realised returns with falling yields.

Lower yields and higher asset prices have brought forward future returns and that couldn’t continue indefinitely. Consequently, we are probably entering payback time for the windfall gains that we’ve enjoyed for so long.

We are now in a higher-inflation world. Until 2022, inflation ran at historically low levels for many years.

Just when we need to earn higher returns simply to beat inflation, expected market returns are about as low as they have ever been in living memory.

 It’s no wonder, then, that we are seeing repeated claims from the asset management industry that the current climate calls for new approaches — particularly unconstrained, high-conviction active strategies like those used by hedge funds.

The arguments for hedge funds

A common view is that hedge funds provide a degree of protection against inflation.  Another argument for hedge funds is that the world has arguably entered a prolonged period of elevated macroeconomic volatility.

According to a recent note from Goldman Sachs, this increased volatility should lead to better investing opportunities for hedge funds.  When short-term cash instruments offer materially higher interest rates, it creates a “total return tailwind” for hedge funds, which typically have large cash holdings.

The new macroeconomic environment benefits the trend-following and directional macro strategies that many hedge funds favour.

A third argument for hedge funds is that they act as a diversifier.

The counter arguments

There are no obvious arguments against investing in hedge funds in a high-inflation, low-return environment specifically, but the case against using them in general is strong.

First of all, even though some funds have moved away from the traditional two-and-twenty charging structure, hedge funds generally remain very expensive. Fees are a significant drag on investment performance.

Hedge funds offer the potential for outperformance, but to make it worth investing in them at all, the alpha they generate must exceed the costs entailed. In most cases, the fees they charge present too big a hurdle for hedge fund managers to overcome.

Secondly, and partly because of their higher expense ratios, hedge funds have consistently produced disappointing returns, particularly since the global financial crisis.

According to consultancy firm Aurum,  hedge fund performance in the five-year period to the end of June 2023 stood at a cumulative abnormal return (CAR) of 4.7%. Although that put hedge funds comfortably ahead of bonds, which were down 1.3% over the same period in US dollar terms, they still lagged equities, which had a CAR of 5.6%.

Another reason for being wary of hedge funds is the additional tail risk they entail. You could win big if a hedge fund’s bets pay off, but you could also suffer large losses. Hedge funds whose strategies involve the use of leverage and derivatives to trade securities are particularly vulnerable to short, sharp shocks.

The 25th anniversary of the collapse of Long-Term Capital Management has put the spotlight on that particular fund in recent weeks, but several other hedge funds have failed as well, including Amaranth Advisors, Tiger Funds and Marin Capital. There are bound to be more failures in future.

Fast pain or slow pain

There are arguments for and against using hedge funds.

For some investors, the short pain option may involve some exposure to hedge funds. If you can identify in advance the right fund manager — and that’s a very big if — you may be able to hit your goals despite the low-return environment.

The alternative is to not to increase your risk, but to focus instead on factors within your control — particularly cost, diversification and discipline. Get those things right, and your chances of outperforming the great majority of investors are very high.

This story first appeared on our sister publication, Portfolio Adviser.

Part of the Mark Allen Group.