Demystifying Hedge Funds · Demystifying Hedge Funds By Justin Tantalo, ... for many investors, with return profiles that tend to exhibit low volatility, low correlations to traditional

Demystifying Hedge FundsBy Justin Tantalo, Senior Lead Research Analyst

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Today’s hedge fund strategies are a core component of robust portfolio diversification for

many investors, with return profiles that tend to exhibit low volatility, low correlations to

traditional investments, and low drawdowns during equity market sell-offs. Hedge funds were

never intended to be panacea for outperformance under all market conditions (those don’t

exist), but when constructed and used correctly, they can make a difference in a portfolio’s

risk-adjusted returns.

Demystifying hedge funds – What are they?

Let’s begin with what hedge fund aren’t — they are not an asset class. Hedge funds are actively managed private fund structures where investment managers have latitude to invest in a variety of asset classes, and often use leverage, derivatives, and short positioning to earn attractive risk-adjusted returns. The objective for a hedge fund manager is to generate meaningful absolute returns across market conditions, with low correlations to traditional asset classes and low volatility of returns. This type of return stream is highly valued among investors for its diversification benefits and is a challenge to consistently deliver.

In the past 30 years, hedge funds have continued to garner a wider investor base. With that said, their distribution continues to be restricted to larger, sophisticated investors who are better positioned to understand the added complexity, structure, and liquidity. In practice, hedge funds are typically restricted to accredited investors and/or qualified institutional buyers.2

Sociologist Alfred Winslow Jones is the father of today’s multi-trillion-dollar hedge fund

industry. In 1949 his partnership, started with $40,000 of his own capital and $60,000 raised

from other limited partners, aimed to enhance investment returns and mitigate risk regardless

of the direction of the overall market by using both leverage (borrowing to invest)

and shorting (selling borrowed securities to profit from price declines).

His ‘hedged’ fund was structured to limit the impact of investment risk from

broader financial markets; instead returns would depend solely on whether the

manager picked the right security to buy or sell. To further align Jones and

his portfolio managers in this venture, he rationalized that he was

entitled to 20% of profits as compensation.1 The hedge fund was born.

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Hedge Fund Assets Under Management (AUM) (dollars in billions)

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Source: Prequin, Key Private Bank

By September 2019, more than $3 trillion was invested in hedge funds, despite the sector seeing net outflows since the global financial crisis (GFC). With the previous five years of net attrition of funds (more closing than opening), the concentration of assets amongst the larger managers continues to grow.

Hedge fund strategies in more detail

Hedge funds trade securities in creative combinations seeking attractive risk-adjusted returns. They primarily fall into one of four main categories:

Equity Hedge (EH) Also known as equity long-short, these funds maintain positions both long and short in primarily equity and equity derivative securities. Net exposure (long minus short) can vary according to the manager’s discretion or can be actively neutralized (in dollar or market exposure ‘beta’) within a subset of strategies known as equity market neutral. Said differently, long/short managers, in addition to the focus on identifying alpha-oriented ideas, possess the added flexibility to tactically adjust the beta of their overall portfolio. Equity market neutral managers, meanwhile, generally keep the beta of their portfolios near zero. A typical trade for a long/short manager involves him/her electing to go long or buy stock ABC believing it is poised to rise, while also going short stock XYZ believing it is poised to lose value.

Event Driven (ED)These funds maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety, including, but not limited to, mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance, or other capital structure adjustments. Strategies attempt to profit from superior probability estimates of events happening and the effect those events will have on price compared to prevailing market estimates.

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Relative Value (RV)These funds maintain positions in which the investment thesis is predicated on realization of a valuation or pricing discrepancy in the relationship between two or more securities. Managers employ a variety of fundamental and quantitative techniques to identify attractive opportunities. Strategies can focus on a specific asset class, such as equities or bonds, or incorporate multiple asset classes and security types. For example, a relative value manager may decide to buy a bond maturing in 2027, while simultaneously shorting a bond of the same issuer maturing in 2029.

Macro (MA)These funds trade a broad range of strategies in which the investment process relies upon movements in underlying economic variables and the impact these have on equity, fixed income, currency, and commodity markets. For example, a macro manager might believe an emerging market country is on the cusp of a positive inflection point and invests in this belief by establishing positions in the country’s currency, bonds, and stocks of companies domiciled there. Strategies can differ based on top-down or bottom-up approaches, holding period, discretionary or systematic processes, risk profile, or any combination of these factors

Each of these categories can be subdivided into strategies that better describe the types of trades, themes, or securities that a hedge fund might traffic in. The most common of them are listed below.

Equity Hedge

• Equity Market Neutral

• Fundamental Growth

• Fundamental Value

• Quantitative Directional

• Sector: Energy

• Sector: Healthcare

• Sector: Technology

• Short Bias

• Multi-Strategy

Event Driven

• Activist

• Credit Arbitrage

• Distressed/

Restructuring

• Merger Arbitrage

• Private Issue/Reg-D

• Special Situations

• Multi-Strategy

Relative Value

• Fixed Income ABS

• Fixed Income

Convertible Arb

• Fixed Income Corporate

• Fixed Income Sovereign

• Volatility

• Yield Alternatives

Real Assets

• Multi-Strategy

Macro

• Active Trading

• Commodity Agriculture

• Commodity Energy

• Commodity Metals

• Commodity Multi

• Currency Discretionary

• Currency Systematic

• Discretionary Thematic

• Systematic Diversified

• Multi-Strategy

Source: HFR, Key Private Bank

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Systematic vs. discretionary investment process

Regardless of strategy, a hedge fund’s investment process can be either systematic or discretionary in nature. Systematic, or quantitative, investing applies a repeatable and data-driven process that relies on computers to identify investment opportunities across large universes of underlying securities. This approach focuses on breadth and typically allows for broader diversification. And while the algorithms are still coded by humans to seek out actionable signals or factors which managers believe are currently mispriced in the marketplace, the ultimate buy and sell decisions are placed automatically. Approximately 20% of total hedge fund assets under management (AUM) was managed by systematic managers in 2018, up from 14% a decade ago (Source: Preqin, 2018).

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Quant HF as % of Total HF AUM (RHS)

Source: HFR, Wellington

Quant AUM (LHS) Discretionary AUM (LHS)

A discretionary manager, on the other hand, focuses on knowing a smaller set of securities exceptionally well. They follow a best-ideas approach and opt for concentration ahead of diversification. Buy/sell decisions, as well as risk management, are directly in the hands of the discretionary manager.

Combining systematic and discretionary strategies within and across strategies can improve diversification. Each approach has its relative benefits and drawbacks, but diversifying can limit the impact of adverse outcomes and improve the risk-adjusted return profile of a hedge fund portfolio.

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Context - How hedge funds differ from traditional mutual funds

Hedge funds differ from mutual funds in several ways, including regulation, ease of access, structure, liquidity, fees, and transparency. The following chart highlights some of the most important differences.

Measure Hedge Fund Mutual Fund

Investor base/LPs Narrower; accredited investors and qualified purchasers

Broader; including individual investors

Return objective Absolute; low volatility Relative; outperformance of defined benchmark

Minimum investment Higher; $1M+ Lower

Investment strategy Unrestricted Restricted

Regulation Lightly regulated Strictly regulated

Fund liquidity Lower; monthly/quarterly Higher; daily

Transparency Lower Higher

Fees Higher; management fee plus performance fee Lower; management fee

Source: Key Private Bank

Hedge fund fees

Absolute, uncorrelated returns are difficult to generate and require investment infrastructure and talent that is expensive to retain. Because of this, hedge funds remain among the most expensive investment strategies found in a diversified portfolio. That said, the industry that matured on its storied 2-and-20 fee structure (2% management fee plus 20% performance fee) has since seen steady fee erosion in both, which Hedge Fund Research (HFR) cites is currently averaging 1.48% and 17.4%, respectively.

Industry AUM by Management Fee Industry AUM by Performance Fee

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Why should an investor care?The case for considering hedge funds

Hedge funds have a specific function in a diversified portfolio: they improve overall risk-adjusted returns. To better understand how this happens, we turn to economic and financial models. These tools are admittedly imperfect, but they do provide some structure when dealing in uncertainty. Modern portfolio theory (MPT) is one of the most famous of these models. Developed by Harry Markowitz in the 1950s, it offers investors a useful model for portfolio construction in a mean-variance, or risk/return, framework.

MPT suggests that traditional assets, like stocks and bonds, arrange themselves in potential portfolio combinations that ultimately form an efficient frontier — a combined portfolio on which no higher portfolio return can be expected without bearing additional risk — using only expected return, volatility, and the covariance between assets. All portfolios below this frontier would be considered inefficient.3 In this framework, adding alternative investments like hedge funds, with their relatively low volatility and uncorrelated returns, offers diversification benefits that cause a shift in the efficient frontier up and to the left. This shift is what Markowitz was referring to when he said that “diversification is the only free lunch in finance”. This is the investment case for adding hedge fund strategies to a portfolio.

Hedge Funds and the Efficient Frontier

Pote

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Stocks, bonds, and hedge funds

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Potential Risk/Volatility

Source: Key Private Bank, MPI Analytics

Ivy League Endowment Asset Class Exposures

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Shown by Fiscal Year 2008-2018

Harvard Yale Princeton Dartmouth Upenn Columbia Cornell Brown

Hedge FundsVenture CapitalPrivate EquityReal EstateNatural ResourcesEmerging MarketsForeign DevelopedUS EquityBonds and Cash

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University endowment managers have embraced hedge funds and have been large allocators over the past 30 years. The absolute return, low correlations to traditional investments, and low volatility of their returns are compelling to the endowments’ objective of financial support for the institution. In recent years, endowments have maintained allocations of approximately 20% of assets to hedge funds.

The past decade: Hedge funds fall short of expectations

Hedge funds have been the subject of increasingly vocal criticism over the past 10 years for their underwhelming returns and high fees. Although much of this criticism is well deserved, some of the disappointment stems from misguided investor expectations throughout the process. Criticism of hedge funds for not keeping up with returns of the S&P 500 Index during one of the strongest bull markets on record is somewhat misdirected. Hedge funds are not tasked with outperforming risk assets under all market conditions. Those investment solutions still do not exist. Instead, their hedged nature suggests that they should be expected to lag equities during bull markets and protect capital during drawdowns, which has indeed been the case over the past 25 years. Returns, when properly adjusted for risk, have not been as catastrophic as some vocal critics might suggest. The line charts below displaying risk-adjusted returns (Sharpe ratio) support this finding.

Interestingly, hedge funds were once much more volatile than they are today. Over the past 20 years, return volatility has been in structural decline, partially due to lower volatility in underlying assets and partially as a result of managers catering to an increasingly institutional investor base that seeks smooth returns. Hedge fund returns in the 1990s had equity-like risk, but this has steadily declined to just under one-third of that level today. It is now on par with bond market volatility. This lower risk has come at the expense of lower returns, but a balanced critique of hedge fund performance would be incomplete without this clarification.

Trailing 3-Year Sharpe Ratio

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Source: Bloomberg, Key Private Bank

Trailing 3-Year Annualized Returns

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CS Hedge Index SP500

Capital preservation

Hedge fundunderperformance

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Relative Volatility of Returns Trailing 3-Year Volatility of Returns

CS Hedge Index SP500 Bbg Barclays US AGG

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CS Hedge Index vs. SP500 (LHS) CS Hedge Index vs. US Agg (RHS)

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We should note that no index or composite representing an investment universe is perfect. The data cited in the above two charts comes from Credit Suisse Hedge Fund Index, an asset-weighted index drawn from a database of more than 9,000 funds worldwide that covers 85% of industry AUM. Its methodology aims to minimize distortions by including a fund until it fails to report monthly performance and AUM for two consecutive months. Importantly, it does not remove historical returns for funds that cease operations. Nor does it backfill historical returns for funds that enter the index. All changes made are on a going forward basis, which helps minimize survivorship and backfill biases inherent in these types of indices. That said, there could be biases on the margin that result from the lack of visibility of nascent funds (sub-$50M AUM), but in our opinion the index remains a reasonable representation of realized returns.

Source: Bloomberg, Key Private Bank

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Downside protection during sell-offs

Hedge funds have a solid track record of protecting capital during equity market sell-offs. The figure below displays the largest 20 monthly drawdowns since September 1999. In each of these instances, hedge funds protected capital better than equities and a balanced portfolio. Moreover, this data is not subject to the biases referenced earlier.

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December 2018:Equities: (7.0%)60/40 Portfolio: (3.5%)Hedge Funds: (2.4%)

MSCI ACWI 60/40 HFR FoF

Source: HFR, Key Private Bank

Some investors argue that bonds provide sufficient and inexpensive portfolio diversification, and thus hedge funds can safely be ignored. The challenge with this argument is that it creates a false dichotomy. There is no disagreement over the place for bonds in a well-diversified portfolio, but it need not be a question of either hedge funds or bonds. In fact, there are a number of risks that can negatively impact returns for both stocks and bonds (e.g., surprise inflation) but which also provide attractive alpha-generating opportunities for hedge fund managers. The experience of the 1970s is far enough from memory for most, but it should act to remind us that stocks and bonds can decline together.

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Sizing, funding, and implementation

As a general rule, Key Private Bank recommends that qualified purchasers allocate 10% of their portfolio to hedge fund strategies, funded 30/70 from equity and fixed income allocations, respectively. As such, a hypothetical investor with a balanced portfolio of 60/40 equity and fixed income would thus instead hold 57% in equities, 33% in fixed income, and 10% in hedge funds.

The 30/70 funding allocation is deliberately skewed towards fixed income and is done with improving portfolio risk-adjusted returns in mind. Consider the risk side first: hedge fund volatility is similar to that of fixed income at ~4% annualized, which is less than one-third of equity volatility. On the return side, since our funding recommendation comes primarily from fixed income allocations, the return threshold required for hedge funds to add value is commensurately low.

Yields are the best indicator of expected returns in fixed income, and our capital markets assumptions for 2020-onward suggest bond returns of 2% (equity returns of 5%). It follows that for a 10% hedge fund allocation to add value, it would require expected net returns above 3% — which is a relatively low threshold to clear — and should do so with lower volatility than the funding basket.4

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Implementation: Direct vs fund-of-funds approach

There are two ways investors build exposure to hedge fund strategies. The first is buying each strategy directly, the approach of choice for large institutional investors like pension funds, university endowments, foundations, and some family offices. Their buying power and investment staff are sufficiently large to accommodate the minimum investment requirements (as high as $10MM) and can undertake the sourcing, underwriting, and monitoring exercises of hedge fund investment, an essential ingredient in building an enduring hedge fund portfolio. For other accredited investors, access to hedge fund strategies can be more efficiently sourced through a fund-of-funds structure. A fund-of-funds comes with its own fees but in return solves issues around sourcing, diversification, investment minimums, and ongoing monitoring. It brings buying power and scale to non-institutionalized investors, allowing them to access strategies that would otherwise be out of reach.

Whether one allocates to hedge fund strategies directly or through a fund-of-funds, the ultimate success of the allocation depends on the quality of underlying manager selection, since return dispersion across managers is high throughout the industry.

HFRI Equity Hedge Index Constituent Returns (%)

Source: HFR, Wellington

120 –

90 –

60 –

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Percentile:95th75thMedian25th5th

Consider the Equity Hedge Segment for Example:

Where the dispersion in the middle two quartiles alone has averaged 15% over the last 10 years. Rigorous manager selection and on-going monitoring are paramount to a successful hedge fund allocation.

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Our outlook for hedge funds in today’s environment

In the 10+ years since the global financial crisis, the market environment has not been conducive to hedge fund investing. A backdrop of abundant liquidity, dampened volatility, and low/declining interest rates coincided with a steady US economic expansion that has stretched into the longest on record. It has been an exceptionally rewarding period for those exposed to risk assets, and relatively less so for those hedging risk and focusing on absolute returns. That said, diversification is not a tactical tilt and is still the preferred way to deal with uncertainty. We are optimistic on the role hedge funds play within a diversified portfolio. Furthermore, we also believe that we may be heading into an environment where hedge funds shine.

Rem

emb

er

• While equity investors have enjoyed 10-plus years of strong performance, at some point, the current cycle will end highlighting the importance of maintaining a well-diversified portfolio.

• Treasury yields and credit spreads are low, offering expected returns with a 2 – 3%annualized ceiling. Bond returns are baked in, and they’re low.

• Corporate indebtedness is at record levels, and complacency in origination andhigher competition from private credit has resulted in covenant loose loans, whichcould surprise on the downside.

• Overall higher volatility could be ahead, an ideal backdrop for skilled hedge fundmanagers, especially now that fees continue to decline and with fewer competitorsin the market.

Successful hedge fund allocation should be expected to protect capital in down markets and improve the overall portfolio’s risk/return profile. Further, when funded from a bond-heavy allocation in today’s low interest rate environment, a diligently sourced hedge fund solution can increase the investment portfolio’s potential and help improve expected outcomes.

To conclude, we remind investors that hedge funds can be a powerful tool for improving

portfolio risk-adjusted returns and encourage them to be wary of dramatic headlines

admonishing hedge funds for failing to deliver on misaligned expectations. They were never

meant to be a panacea, outperforming all risk assets under all market conditions.

1 20% of the fund’s investment gains are reserved for the management team, invoking the Phoenician sea captains who kept a fifth of the profits from successful voyages. (Mallaby; 2010).

2 In the US, an individual can be considered an accredited investor if she/he passes a net worth threshold (usually $1M, excluding primary residence) or an annual income threshold ($200,000 single or $300,000 if married). See www.sec.gov for more.

3 ‘Inefficient’ in that either it entails more risk for a given level of return, or said alternatively less return for a given level of risk.4 The expected return of funding assets is 0.3*(5%) + 0.7*(2%) = 2.9%. This can be thought of as the opportunity cost for the allocation.

This piece is not intended to provide specific tax or legal advice. You should consult with your own advisors about your particular situation.Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.Investment products are:

NOT FDIC INSURED • NOT BANK GUARANTEED • MAY LOSE VALUE • NOT A DEPOSIT • NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY

©2020 KeyCorp. KeyBank is Member FDIC. 200204-737830

For more information about how hedge funds might fit into your portfolio strategy, contact your Key Private Bank advisor.

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About the Author Justin Tantalo has 15 years of experience in investment management, both in Asset Allocation and Fund Management. As a Senior Vice President with Key Private Bank, Justin applies his expertise in Asset Allocation and helps oversee the equities and alternatives third-party manager research effort.

Justin received an MA in Economics from the University of Waterloo (Canada) and BA in Economics from the University of Western Ontario (Canada). Justin is a CFA Charterholder.