Alternative investments represented $13 trillion in assets under management (AUM) in 2021, almost double what they were in 2015. By 2026, this figure is expected to reach more than $23 trillion, according to Preqin research. Boom times are here for venture capitalists, private equity (PE), and hedge fund managers.
Although 2022 has not been good for venture capital, among other alternatives, some fund managers are doing better than others. For what? Because they can refine the valuations of their investments. Private equity funds do not have daily mark-to-market accounting, so they can smooth losses over multiple quarters.
The ingenuity of this practice is that even though they have similar risk exposure PE returns appear uncorrelated to stocks. On paper, everything looks great.
Correlations are the hallmark of alternative investments. Generating uncorrelated returns in a year where the traditional 60/40 equity bond portfolio posted double-digit losses is a quick way to capture investor interest and capital. However, correlations are like icebergs floating in the sea, there are many things hiding under the surface.
So what are the pitfalls of using correlations to choose alternative strategies?
To find out, we’ve selected seven well-known strategies from the hedge fund universe that have attracted billions in capital allocations. Our data comes from HFRX, whose daily returns date back to 2003. This nearly 20-year period covers several market cycles where alternative strategies should have demonstrated their value by providing diversification benefits.
We calculated the correlations of these hedge fund strategies with traditional asset classes. Three of these strategies – equity hedging, merger arbitrage and event driven – have S&P 500 correlations above 0.5. It wouldn’t make much sense to add them to a stock portfolio given their similar risk profiles.
However, three strategies demonstrated low correlations with equity markets without strong correlations with US investment grade bonds. This suggests that they may offer some value to investors.
Hedge Fund Strategies: Correlations with Stocks and Bonds, 2003 to 2022
Quantifying the benefits of diversification
When presented with a range of alternative strategies, a capital allocator should select those with the lowest correlations to stocks and bonds because they have the highest potential for diversification.
To test this hypothesis, we sorted the seven hedge fund strategies by their average correlations to stocks and bonds and ran simulations that added a 20% allocation to each strategy to a 60/40 stock-bond portfolio. , then rebalanced on a quarterly basis.
Contrary to expectations, adding an alternative allocation did not improve Sharpe ratios for the period 2003 to 2022.
What’s even more unusual is that there doesn’t seem to be a relationship between the correlations. For example, merger arbitrage had a higher average correlation with stocks and bonds than market neutral stocks. Yet adding the latter to a traditional portfolio did not lead to a significantly higher Sharpe ratio.
60/40 portfolio plus 20% alternative allocation: Sharpe ratios, 2003 to 2022
We then calculated the maximum drawdowns for all portfolios. This all happened during the Global Financial Crisis (GFC) in 2009. Stocks and bonds fell, much like they did this year.
Our equity-bond portfolio plunged 35%, while our diversified portfolios all fell between 31% and 39%. Such risk reduction is not particularly impressive.
But as with our previous Sharpe ratio analysis, the maximum drawdowns did not decrease further when more diversified alternative strategies were added.
We would expect a linear relationship between decreasing correlations and declines, at least until the correlations reach zero. If they get too negative, like with a tail risk strategy, the benefits of diversification deteriorate again. We expect a disgruntled smile, but no one smiles.
So, do correlations frustrate investors in their efforts to identify useful alternative strategies?
60/40 plus 20% portfolio Alternative allocation: maximum drawdowns, 2003 to 2022
Fair weather correlations
A partial explanation for our results is that the correlations are misleading. Even if they are close to zero on average, there can still be periods of strong correlation. Unfortunately, correlations often increase exactly when investors demand uncorrelated returns.
Take merger arbitration For example. The strategy is generally uncorrelated to stocks, but when stock markets crash, mergers crash. A portfolio with long positions in companies likely to be acquired and short positions in acquiring companies can be constructed as beta-neutral. But that doesn’t negate the business cycle risk, which is also inherent in equities.
Our seven alternative strategies all lost money during the global financial crisis between 2008 and 2009. Convertible arbitrage lost even more than equities. It’s quite an achievement since the S&P 500 fell by 53%.
Performance of hedge fund strategy during the global financial crisis (GFC), 2008 and 2009
If not, why have the alternatives failed to improve Sharpe ratios and reduce drawdowns? Because, frankly, they’re terrible at making money. They can generate attractive returns before fees, but their net returns to investors have been poor over the past 19 years.
The S&P 500 has produced a CAGR of 9.5% for the period 2003 to 2022, but that’s not the right benchmark for hedge fund strategies. Beating bonds is a more reasonable goal, and only merger arbitrage has achieved that. And this strategy is too strongly correlated to equities to offer much diversification.
Inflation was around 2% for this period, so CAGRs below this level imply negative real returns. Inflation is much higher today, so the goals of these strategies have strayed much further.
Hedge Fund Strategy Performance: CAGR and Correlations, 2003 to 2022
Correlations alone are not enough to identify alternative strategies. A more nuanced approach is needed. Specifically, investors should measure correlations when stocks fall. This will eliminate merger arbitrage and other strategies that carry inherent economic risk.
If calculated correctly, this should reveal that most private asset classes – PE, VC and real estate – have the same risk. They therefore offer limited diversification benefits. We need better tools to measure the diversification potential of alternative strategies.
Of course, that doesn’t change the underlying problem: many strategies no longer generate positive returns. The average equity market-neutral fund, for example, has lost 0.4% per year since 2003.
The case for uncorrelated negative returns is not strong.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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