As equity markets rise, long-term expected returns are falling, leaving growth focused investors with a difficult choice as to where to allocate their funds. In this article, we explore the use of alternative asset managers (also known as hedge funds) as a means of gaining equity-like investment returns while providing downside protection in the event of a market correction.
Equities are trading at record valuations
Stock markets are now trading at extremely elevated levels. Although the Australian market is still below the peak reached prior to the GFC, the U.S. market has hit record highs and in valuation terms is now more expensive than any other period in history other than the peak of the dotcom bubble.
Expected returns are falling
Elevated asset prices have a direct flow-on to reduced long-term expected returns for equities. While independent analysts such as Morningstar are now forecasting long-term total returns for equities of just over 7%, others such as the leading U.S. fund manager GMO have a much more negative view with a forecast negative 4.2% per annum return for U.S. large cap equities over the next seven years.
Should investors adopt a more defensive asset allocation?
The question for investors, particularly those with a high allocation to growth assets, is whether now is the time to adopt a more defensive asset allocation by shifting funds to cash or bonds.
The problem is that timing the market is very difficult, if not impossible, so an investor that moves funds to cash or bonds risks missing out on any further growth in asset values.
What other options do investors have?
Alternative equity strategies offer a potential solution to this problem. Also known as hedge funds, these managers attempt to generate equity like investment returns but with less correlation to equity markets. In a market downturn, they can offer downside protection for investment portfolios and potentially generate positive performance depending on fund exposures at the time.
There are several different styles of hedge fund, each with very different risk profiles. Following are some profiles of the funds we recommend to clients as well as one example of the type we will generally avoid.
Systematic Global Macro Funds
System global macro funds build portfolios that target absolute returns throughout the market cycle.
The funds trade macro derivate instruments i.e. futures markets, both long and short, across a broad universe of markets including equity indices, government bonds, commodities and currencies. They use proprietary quantitative tools to build diversified portfolios with the majority of risk taken in market neutral trades.
In the example below, the fund manager has generated an average annual return of 8.5% over a 10 year period without any negative performance years.
Dynamic Multi-Asset Real Return Funds
Similar to systematic funds, multi-asset real return funds target absolute returns throughout the investment cycle and invest across a broad investment universe.
Unlike systematic funds, however, multi-asset real return funds build portfolio positions within a fundamentals-based forward view of markets rather than relying predominantly on quantitative tools. Portfolio risk is still managed through over/underweight positions based on conviction levels and the ability to rapidly switch between asset classes in response to market conditions.
Our preferred manager in this category takes a 3-5 year horizon on market return expectations, allowing them to reduce portfolio turnover and access a broader range of investment options including direct security exposures. As can be seen from the performance graph below, returns from this style of manager can be more volatile than systematic funds while still providing downside protection.
Market Neutral Equity Funds
Market neutral equity funds aim to provide attractive, risk-adjusted absolute returns with little or no net exposure to underlying equity markets. The funds invest in similar sized long and short portfolios which have been constructed based on a fundamental investment process. Returns are generated by capturing the ‘spread’ between the long and short portfolios.
These funds have the advantage of carrying limited downside risk although positive returns will depend on the manager’s ability to pick ‘winners’ and ‘losers’. Given their market neutral portfolio weight, returns will generally be lower than equities in a rising market but higher in a falling market.
Managed Futures Funds
Managed futures funds have a similar investment universe to systematic global macro funds and aim to generate positive long-term returns.
These funds use trend-following programs to allocate to markets across all asset classes which are experiencing sustained movement up (long investment) or down (short investment).
Managed futures funds produce volatile returns (often with limited transparency) and are not among the products we recommend to clients. As depicted below, they can produce substantial negative returns when there are rapid shifts in market momentum.
Conclusion
We think that select alternative fund managers present an attractive risk/reward profile in a market where asset prices are elevated. They offer the opportunity to capture further equity market upside while providing potential protection in the event of a market downturn. It is for this reason that we are starting to allocate a portion of our clients’ funds to the alternatives asset class.
Disclaimer
This publication is issued by JJT Advisory Pty Ltd and is intended to be general information only without taking into account the investment needs, objectives and financial circumstances of any particular investor.
Past performance is not a reliable indicator of future performance.