Diversified sources of risk and return are essential for every investor, and hedge funds have historically played an important role in achieving this goal. While hedge funds have continued to offer diversification in recent years, there has been significant dispersion in manager performance. What can investors do to seek consistency of diversification and performance?
We suggest that investors consider alternative risk premia strategies. We estimate that roughly a third of the total risk across a broad sample of hedge fundsi is driven by traditional or alternative risk premia. However, risk premia can be accessed at much lower cost and with higher liquidity. We believe investors can get more from their hedge fund allocation by selectively replacing part of their portfolio with exposures to alternative risk premia.
Revisiting recent hedge fund performance
The broad hedge fund universe returned 3.8% annualized over the seven years ended December 2016, compared to the 7.9% return from global equities and the 4.0% return from fixed income (see Figure 1). The difference in performance versus equities should not be surprising: Strategies designed to diversify away from equities are not likely to fare well during a strong equity bull market. Furthermore, unprecedented central bank intervention over this period has suppressed volatility in financial markets, creating a challenging environment for strategies designed to capitalize on market dislocations.
There has also been a high degree of dispersion in performance among hedge funds, as shown in Figure 1. Top-quartile hedge fund managers in our broad sample delivered an annualized return of 9.2%, handily outperforming the median hedge fund manager by 3.5 percentage points per annum. The top performers (95th percentile) delivered 17.1% in annualized return, outperforming peers and the broad market by an even wider margin. This highlights the importance of manager selection. However, while everyone desires an allocation to star performers, finding them on a consistent basis is challenging. Some of the top funds are capacity-constrained and thus closed to new investors.
Critically, investors evaluating hedge fund allocations shouldn’t focus solely on the level of performance versus traditional assets, as is often the case. They should also look at where the performance comes from. A truly diversifying asset can be useful in portfolio construction even if its stand-alone returns are lower than or similar to those of traditional asset classes.
Dissecting hedge fund risk
Underlying risk in a hedge fund, or for that matter any active strategy, stems from exposure to three sources: traditional risk premia, alternative risk premia, and alpha (see Figure 2). Traditional risk premia represent returns attributable to broad exposures – equities, interest rates, commodities, credit and currencies. Alternative risk premia represent returns driven by (implicit or explicit) allocations to well-known and persistent sources of excess return such as value, momentum, carry and risk aversion (see Figure 3). Finally, alpha represents the return achieved through security selection and timing.
Typically, investors in hedge funds expect little exposure to traditional and alternative risk premia because these can be accessed elsewhere at much lower cost. Ideally, investors want most hedge fund risk to be driven by alpha – as we strive to do in all discretionary PIMCO hedge funds – as this produces idiosyncratic risk, which tends to have low or negative correlations with other assets, and amplifies the diversification benefits investors seek. However, it is important to note that diversification does not ensure against loss.
Evaluating sources of hedge fund manager risk
The key drivers of return and risk within hedge funds can be estimated through quantitative analysis. Multiple regression can be a powerful tool in uncovering whether a hedge fund manager has systematic exposures to traditional or alternative risk premia, which in turn may reveal a conscious or unconscious style bias in the manager’s process.
To illustrate this point, let’s look at the risk profiles of two hypothetical managers (see Figure 4):
While both managers delivered identical returns with the same level of volatility, the sources of those returns varied markedly. Only 20% of manager A’s risk can be explained by exposures to traditional and alternative risk premia. In contrast, at 80%, manager B’s risk profile reflects significant exposures to risk premia. So even though both managers delivered the same return at the same risk level, an allocation to manager A would have been superior from a portfolio diversification perspective because most of the risk is driven by idiosyncratic sources.
In assessing a hedge fund manager’s real “value add,” then, another benchmark could be helpful: one that excludes returns attributable to traditional and alternative risk premia. If alpha is negative relative to this benchmark, an investor may want to consider whether the investment results are consistent with the manager’s investment proposition. In particular, hedge funds billed as market-neutral or relative-value should produce returns primarily through idiosyncratic risk sources.
This analysis is critical from a diversification perspective. Given that most investors hold significant exposures to traditional risk premia in other parts of their portfolios, overlapping exposures within the hedge fund allocation may reduce overall portfolio diversification.
Evaluating manager performance
We used a multi-factor regression analysis to evaluate the persistence of common risk-factor exposures among 300 of the largest hedge fund managers. This sample included managers within eight different strategy cohorts with at least $250 million in assets under management (AUM) and seven years of performance history as of September 2016 (based on data from Eurekahedge).
Our analysis produced three key takeaways. First, many hedge funds have meaningful exposure to traditional risk premia. In particular, equity risk, which tends to dominate most investor portfolios, accounted for a substantial portion of the risk in certain categories, with significant variation within most categories. (See Figure 5).
Second, on average, common risk premia explained one-third of the risk. Their prevalence varied by category, ranging from 25% for relative-value hedge fund strategies to 41% for CTAs (commodity trading advisors), which tend to have systematic exposures to the momentum factor.
Finally, there is significant variation in exposures to traditional and alternative risk premia among managers in the same category. Consider the “macro” strategy category, where risk premia explain anywhere from 4% to 96% of manager risk. While the heterogeneous nature of strategy implementation may be partially responsible, the wide range also reveals the importance of not relying simply on category-level diversification when constructing a hedge fund portfolio. Instead, it is critical to evaluate each manager’s sources of risk and return to ensure they are in line with expectations (see Figure 7).
Impact on portfolio efficiency
Our analysis highlights three criteria that investors can use to evaluate the cost and effectiveness of hedge fund allocations:
Is there persistent exposure to traditional risk premia (e.g., equity risk)?
Is there persistent exposure to alternative risk premia (e.g., value, carry, momentum)?
Are there persistent exposures that are inconsistent with a manager’s stated investment style (i.e., style drift)?
Persistent exposure to traditional risk premia, such as equities, is likely to reduce the diversification benefits of the investment. Given that traditional risk premia already account for the bulk of risk in most portfolios, investors may want to avoid managers who have sizeable exposures, especially if alpha makes zero, or worse, a negative contribution to overall returns.
In contrast, exposure to alternative risk premia may offer a complementary source of return and attractive diversification benefits to a broader portfolio. However, investors may be best served by allocating directly to systematic alternative risk premia strategies rather than to discretionary hedge strategies. Several dedicated alternative risk premia strategies offer greater liquidity and lower fees.
Finally, investors should ensure that a hedge fund manager’s risk profile is commensurate with the stated investment style. For example, an equity market-neutral strategy should not have a significant proportion of risk explained by equity beta.
In conclusion, risk premia account for at least 50% of the risk in about one-quarter of the typical hedge funds in our sample. Therefore, we believe investors have ample room to increase portfolio efficiency by replacing certain managers and allocating to more cost-effective strategies.