February 14, 2023
How Hedge Funds Can Improve Portfolio Diversification
February 14, 2023
How Hedge Funds Can Improve Portfolio Diversification
February 14, 2023
Judging a book by its cover has a bad rap for a good reason—it’s an unreliable guide to what’s inside. There’s a similar issue with the “hedge fund” label—it tells you nothing about the strategy the manager is pursuing. In a sustained bull market like the one that ended after 2021, when most hedge funds appreciated along with other risky assets, that isn’t necessarily a problem.
Of course, 2022 was a much different environment. An “alternative” diversifier would have been very beneficial, given that the traditionally diversified 60% stock/40% bond portfolio1 experienced its worst drawdown since the Great Depression, losing 15.9%.
In conversations with investors and other market observers, we found that many expected their hedge funds to provide diversification for their traditional market portfolio. Hedge funds overall certainly held up better than the broad equity market in 2022, with the HFRI Fund Weighted Composite Index losing -4.2%, compared with a drop of 17.7% for the MSCI World Index Gross (USD).
But for investors looking for a positive bounce from this part of their portfolio—especially those who expected their hedge funds to have no correlation to stocks—the results were disappointing. That's especially true for those invested in the large segment of the fund universe that did substantially worse than the HFRI Fund Weighted Composite.
However, many funds delivered positive and even double-digit returns in 2022. This paper examines how investors can structure their hedge fund portfolios to increase the odds that performance will be in line with expectations, especially if the goal is to add diversification to stock and bond portfolio allocations.
Hedge funds are generally understood to be vehicles that seek alpha in an unconstrained fashion, using techniques such as leverage and short selling to boost returns, emphasizing a goal of positive absolute returns through most market environments. In fact, hedge funds are not really an asset class, but a legal structure that encompasses a wide range of strategies across every underlying asset type or investment product set.
Display 1A shows that over the past three decades, the correlation between the broad hedge fund index and the MSCI World Index has been steadily increasing. Display 1B shows that as a result, during the five worst equity drawdowns since 1990, the broad hedge fund index also lost money in four of those periods.
Display 2 helps explain the results in Displays 1A and 1B. During the recent sustained bull market, many investors in hedge funds and fund of funds gravitated to strategies that have performed well in pro-cyclical regimes. The assets of two hedge fund sectors with highest-beta strategies—Equity Hedge and Event Driven—increased by $656 billion over the three years leading into 2022, more than three times the increase for Relative Value and Macro strategies.
Like the unhelpful broad “hedge fund” label, Equity Hedge and Event Driven can give the impression that they should be uncorrelated with equity and bond markets. Indeed, they do employ hedging and invest in alternative markets and assets not typically found in a 60/40 portfolio.
Nonetheless, Equity Hedge and Event Driven are exposed to the same risk premia found in a 60/40 portfolio, as illustrated by their performance in 2022—Equity Hedge fell by 10.4% and Event Driven fell by 5.0%.2 A closer examination of their strategies shows why this should not surprising.
For example, long-biased equity funds typically hedge only a portion of their long position. In the Event Driven space, credit funds often take positions in illiquid debt, including emerging markets, which had an awful year in 2022.
Decades of high correlation
Display 3 shows that 2022 was no fluke. Equity Hedge and Event Driven have been highly correlated with equities for the past two decades, and left investors exposed to market pullbacks in 2018, 2020, and 2022, reducing the diversification power of their alternative portfolio.
Relative Value is only modestly lower in correlation, while Macro has achieved a materially low correlation.
Good records in bear markets
Fortunately, a number of hedge fund strategies have historically provided strong diversification to equities. The Macro sector was particularly successful in 2022, with a total return on the HFRI Macro (Total) Index of 9.0%. A number of the Macro sub-sectors produced double-digit returns, including systematic diversified, systematic directional, currency, and commodities.
In fact, Macro and Fixed Income Relative Value sectors have had consistently strong relative performance during bear markets, as seen in Display 4. It also highlights that the Equity Hedge and Event Driven strategies have underperformed the hedge fund average consistently during those down periods.
But even within the Equity Hedge category, there are strategies that perform well in bear markets, such as Equity Market Neutral. As the name implies, the strategy is focused purely on security selection and removes all market exposure. This strategy requires a high degree of skill and sophistication given the portfolio gets no “free” boost from rising equity markets. While Equity Market Neutral is only 2% of total exposure with the HFRI universe, it is the prevalent strategy in popular hedge fund platforms, such as Millennium and Citadel.
Next, we offer our view on the strategies we believe likely to diversify a 60/40 portfolio and potentially deliver stronger alpha than they have in the past decade.
Volatility as a tailwind
Prior to 2022, the ultra-low interest rates and quantitative easing by the U.S. Federal Reserve and other central banks helped drive investors into risky assets, which was a tailwind for all stocks. That helped reduce dispersion among individual equities, tightening the range between best- and worst-performing issues, and depriving fund managers of alpha opportunities.
Now, however, with price moves that are more frequent and extended, a much broader range of opportunities opens up for a variety of hedge fund sectors. For example, in Equity Market Neutral, sharper price movements can push long and short positions farther in their trading ranges, potentially boosting profits.
Short rebate inflates
Rising interest rates provide yet another direct benefit to highly hedged strategies. To see how, consider a short-selling transaction by a typical long/short equity fund. When the fund sells borrowed shares, the cash proceeds from the sale generate interest, which belongs to the lender of the stock. However, the fund is typically entitled to a portion of that interest, known as the short rebate.
With the effective federal funds rate at 0% in nine of the last 13 years, the short rebate had zero benefit for equity long/ short funds. But with federal funds exceeding 4% at the start of 2023, the short rebate is expected to be significantly additive to long/short equity returns.
CTAs profiting from cash
Commodity Trading Advisors (CTAs) comprise another hedge fund category set to benefit from rising rates. The futures positions typically employed by these funds only require a relatively small margin payment as a percentage of the value of those contracts, which leads to high levels of unencumbered portfolio cash.
The shift from zero percent interest rates to a new inflation-fighting policy regime has boosted the return on cash and added hundreds of basis points to potential return of CTA strategies. Likewise, many Discretionary Macro and Fixed Income Relative Value strategies that carry 40%-60% unencumbered cash or greater stand to benefit from this tailwind for gross returns.
Relative value in Treasuries
Fixed-Income Relative Value strategies are also flourishing with the increase in interest rate volatility, as can be seen in the U.S. Treasury market. Despite being the largest and most liquid market in the world, discontinuities in pricing can occur along the yield curve that make particular issues over- or undervalued.
The Treasury curve can be discontinuous for a variety of reasons. For example, a big pension fund may be swapping into or out of a particular issue, or another issue may be deliverable for an expiring futures contract, creating a spike in demand. The degree of over- or undervaluation can be estimated relative to the interest-rate swap curve. These are highly popular private contracts in which investors agree to swap fixed for floating payments for a set time, for a number of reasons, such as hedging floating-rate liabilities.
Additionally, the Fed’s balance sheet reduction through quantitative tightening forces the market to absorb greater volumes of Treasury issues. Historically, shrinking Fed balance sheets have corresponded with increased inefficiencies along the curve. In today’s market, the impact of this factor as a driver of volatility is even greater because of lower Treasury market liquidity, thanks largely to reduced participation by primary dealers.
The bottom line is that Relative Value hedge funds can find a growing number of opportunities as providers of liquidity, and in general, take advantage of inefficient Treasury pricing as it appears along the curve.
Drivers of hedge fund engines
In 2022, many investors were disappointed to find that their hedge funds were strongly correlated with equities at the same time traditional 60/40 allocation failed to provide downside protection. However, we have shown that many hedge funds offered successful diversification in a difficult year, and many are likely to be effective diversifiers going forward. Knowing what drives a hedge fund’s engine is key to predicting its direction when the stock market heads south.
HFRI 500 Fund Weighted Composite Index: global, equal-weighted index of the largest hedge funds that report to the HFR Database which are open to new investments and offer quarterly liquidity or better. The index constituents are classified into Equity Hedge, Event Driven, Macro or Relative Value strategies.
HFRI Equity Hedge (Total) Index: Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50% exposure to, and may in some cases be entirely invested in, equities, both long and short.
HFRI Event-Driven (Total) Index: Investment Managers who 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. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.
HFRI Macro (Total) Index: Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.
HFRI Relative Value (Total) Index: Investment Managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.
MSCI World Index: a free float adjusted market capitalization weighted index that is designed to measure the global equity market performance of developed markets. The term “free float” represents the portion of shares outstanding that are deemed to be available for purchase in the public equity markets by investors. The performance of the Index is listed in U.S. dollars and assumes reinvestment of net dividends.
Risk Considerations [Refer to appropriate disclosure guide]
Diversification does not eliminate the risk of loss.
The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.
Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.
This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.
This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.
Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.
The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.
This material is not a product of Morgan Stanley’s Research Department and should not be regarded as a research material or a recommendation.
The Firm has not authorised financial intermediaries to use and to distribute this material, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this material is appropriate for any person to whom they provide this material in view of that person’s circumstances and purpose. The Firm shall not be liable for, and accepts no liability for, the use or misuse of this material by any such financial intermediary.
This material may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this material in another language, the English version shall prevail.
The whole or any part of this material may not be directly or indirectly reproduced, copied, modified, used to create a derivative work, performed, displayed, published, posted, licensed, framed, distributed or transmitted or any of its contents disclosed to third parties without the Firm’s express written consent. This material may not be linked to unless such hyperlink is for personal and non-commercial use. All information contained herein is proprietary and is protected under copyright and other applicable law.
This material is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.
MSIM, the asset management division of Morgan Stanley (NYSE: MS), and its affiliates have arrangements in place to market each other’s products and services. Each MSIM affiliate is regulated as appropriate in the jurisdiction it operates. MSIM’s affiliates are: Eaton Vance Management (International) Limited, Eaton Vance Advisers International Ltd, Calvert Research and Management, Eaton Vance Management, Parametric Portfolio Associates LLC, and Atlanta Capital Management LLC.
This material has been issued by any one or more of the following entities:
This material is for Professional Clients/Accredited Investors only.
In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at The Observatory, 7-11 Sir John Rogerson’s Quay, Dublin 2, D02 VC42, Ireland.
Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.
In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.
Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority.
Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain. Germany: MSIM FMIL Frankfurt Branch, Große Gallusstraße 18, 60312 Frankfurt am Main, Germany (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Denmark: MSIM FMIL (Copenhagen Branch), Gorrissen Federspiel, Axel Towers, Axeltorv2, 1609 Copenhagen V, Denmark.
Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158).
NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT
Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than to (i) an accredited investor (ii) an expert investor or (iii) an institutional investor as defined in Section 4A of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); or (iv) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore. Australia: This material is provided by Morgan Stanley Investment Management (Australia) Pty Ltd ABN 22122040037, AFSL No. 314182 and its affiliates and does not constitute an offer of interests. Morgan Stanley Investment Management (Australia) Pty Limited arranges for MSIM affiliates to provide financial services to Australian wholesale clients. Interests will only be offered in circumstances under which no disclosure is required under the Corporations Act 2001 (Cth) (the “Corporations Act”). Any offer of interests will not purport to be an offer of interests in circumstances under which disclosure is required under the Corporations Act and will only be made to persons who qualify as a “wholesale client” (as defined in the Corporations Act). This material will not be lodged with the Australian Securities and Investments Commission.
This material may not be circulated or distributed, whether directly or indirectly, to persons in Japan other than to (i) a professional investor as defined in Article 2 of the Financial Instruments and Exchange Act (“FIEA”) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other allocable provision of the FIEA. This material is disseminated in Japan by Morgan Stanley Investment Management (Japan) Co., Ltd., Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.