Liongate’s Mark Parsonson outlines the attraction of hedge funds

Mark Parsonson, executive director of Liongate Capital Management, says there are key advantages in the hedge fund approach, which make them an attractive capital allocation option.

Global monetary policy has succeeded in creating asset price inflation by distorting the productive capital allocation function of markets. Against a backdrop of weak economic growth, markets have benefitted from the unprecedented expansion in global liquidity. Long-term equity valuation measures, such as Tobin’s q and CAPE – indicate over-valuation. Nominal bond yields have declined to levels for which there are few, if any, historical precedents. Where history does, and can, act as a guide, it shows that for many assets, the risk premia earned at comparable valuation levels has tended to be associated with exceptionally low long-term expected returns and worse, significant downside risks.

The decline in available long-term expected returns and the increase in downside risk should be the foremost concern of all investors. Underfunded pension plans will need to adopt new policies to generate the return required to bridge the gap between assets and liabilities. Entitlement reform from effectively bankrupt governments will force investors to rely more on private savings. In a low return world, these are formidable challenges.

Over the most recent market cycle, hedge funds have been criticised for under-performance. Comparisons of hedge fund returns to those of broad equity and credit markets are wrong. The source of this misunderstanding is derived from the limitations of the traditional “asset allocation” framework. Hedge funds are often misclassified as an asset class for investment purposes. This places them on a par with equities and credit. Hedge funds are then restricted to an alternative’s “bucket” within broader strategic asset allocations. Due to a lack of familiarity and the perception of complexity, these buckets typically represent small percentages of portfolios.

This framework is both incorrect and severely limiting. Hedge funds are a group of investment strategies. Their core advantage lies in their ability to use techniques that other investors, such as long-only mutual funds, are unable to employ due to regulation. The perception this creates is one of higher risk, yet many of these, when applied correctly, actually reduce risk.

During periods of above average asset class returns, hedge funds should be expected to consistently lack the upside participation because they have hedged market exposure. Comparisons to other asset classes can lead to investor fatigue and, eventually, capitulation. The lack of private client investment in the industry is an indicator of this.

Yet the value of hedge funds remains undiminished. In reality, their value has increased meaningfully as other assets have been distorted by financial repression. The most sophisticated institutions understand this and now dominate the investor base of the hedge fund industry.

Portfolio diversification is the key to generating adequate long-term risk-adjusted returns. Albert Einstein once noted that the principle of compounding is the most powerful force in the universe. Avoiding significant losses is an essential pillar of this principle. In periods where portfolios are below their high water mark, returns generated merely serve to recapture previous gains, rather than generate new compound returns.

Over-valuation increases the risk of capital loss. While the future remains uncertain, historical precedent demands investors adopt a prudent approach to their current capital allocations. The ‘rotation’ from debt to equity offers limited benefits, merely shifting risk from one over-valued asset to another. This is caused by and represents the limits of the traditional “asset allocation” framework.

Reconstructing the portfolio framework to take more account of underlying risks highlights more clearly the benefits of hedge funds. By understanding that hedge funds are investment strategies their role in portfolios is fundamentally altered. The underlying investments of hedge funds are (broadly) traditional equity and credit instruments. By applying unique investment strategies to these, hedge funds seek to extract differentiated risk premia from the market than buy-and-hold approaches. They do so while hedging much of their market exposure. As a result, they can be used to de-risk traditional investments while gaining exposure more efficiently to risks required to generate sufficient long-term returns.

In recent weeks we have seen the impact concerns over the withdrawal of central bank liquidity have had on bond and equity markets globally. These concerns may be premature but they illustrate the dangers embedded into the current investment landscape. Seeking ways to diversify and mitigate these risks will be essential to generating adequate future returns. By this measure, hedge funds are currently one of the most attractive capital allocation options.

 

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