IndexIQ: Hedge Funds Due For A Comeback?

May 16, 2016

[The following "ETF Industry Perspective" is sponsored by IndexIQ]

To paraphrase Tolstoy, all out-of-favor asset classes are generally out of favor for their own idiosyncratic reasons. Take hedge funds, for example. As an asset class, these vehicles were taken to task for much of 2015 for their fees and below-average performance. But that’s not the whole story.

Misperceptions

In our view, there are three significant misperceptions that have led to this avalanche of criticism. First, average hedge fund performance masks a broad disparity in the returns among both individual funds and strategies. Through December, the average hedge fund was down 1.11% as measured by the HFRI Fund Weighted Composite Index. At the strategy level, however, returns ranged from up 5.9% for the HFRI RV: Volatility Index to a decline of nearly 16.6% for the HFRI RV: Yield Alternatives Indextwo very different experiences (source: Hedge Fund Research, as of 12/31/15).

Second, there’s a general misperception about the role hedge funds should play in an investor’s portfolio. Too often the word "hedge" is discounted and all funds are assumed to be absolute-return vehicles designed for “shoot the lights out” performance. The reality is different. Many do hedge in the classic sense—taking positions that seek to lower market exposure, reduce volatility and help protect against drawdown. Others seek noncorrelated strategies that are designed to zig when the market zags.

Third, looking at historical hedge fund performance, the data show that hedge funds as a group typically provided 3–6% returns over the risk-free rate. Given that the risk-free rate has been zero for quite a while, returns expectations would then be in the 3–6% range. While this may not be exciting to investors experiencing a bull market in equities and fixed income, it’s clear that over the past three-year period, hedge funds as a group have in fact generally performed as they have historically.

A Turnaround In 2016?

That said, there is reason to believe that 2016 may see opportunities emerge for some hedge funds to deliver outperformance versus their long-only peers. Market volatility continues to climb and the Fed continues to have everyone on edge. More than one prognosticator is suggesting that the year may see significant divergence in the performance of various asset classes, with bonds and stocks perhaps heading in different directions and global markets whipsawed by currency moves and divergent central bank policies.

To find a specific example, look no further than Japan, which saw the Bank of Japan make a surprise move toward negative rates. In the immediate aftermath of that announcement, the dollar spiked versus the yen, only to plummet nearly 2% just a few days later. It’s been common to hear many in the alternative space lamenting the lack of volatility in recent years. Those lamentations are likely behind us, and nimble managers may find interesting opportunities emerging at various points around the world.

Taking a look at liquid alternatives, these may offer the well-known advantages of lower costs, better transparency, and greater tax efficiency and liquidity when compared with traditional hedge funds. The range of available strategies is growing as well, and therein lies the challenge for investors and advisors in 2016. As the number of strategies grows, investors gain the flexibility to better manage through a wide range of market conditions.

At the same time, however, it becomes more important than ever to understand how liquid alternatives can be used in portfolio construction when suitable. That term “liquid alternatives” is one that has been stretched to encompass many disparate product types and strategies. But what one “liquid alternative” fund is designed to deliver may be vastly different from the characteristics of another similarly labeled fund. As we’ve seen with hedge funds, there is a risk of misperception about the role liquid alternatives may play in portfolios and just what investors should look for from different liquid alternative offerings. Education and track record have been, and will continue to be, the keys.

As we continue through the year, there’s one trend that you can take to the bank: Most outlooks about the performance of the markets in 2016 may not hit the mark. The only questions are, by how much, and in which direction? Acknowledging this to be the case, suitable investors should consider liquid alternatives as a way to maintain exposure to a broad range of markets and investment strategies, while providing some cushion against a potential market downturn and continued volatility.

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