The MAC Appeal

Hedge funds have broken assurances of consistent earnings

By Jon C. Ritz
Guest Columnist

Hedge funds’ assets flourished from $500 billion in 2000 to almost $3 trillion in 2015 by offering investors the promise of consistent revenue generation with a low-risk asset correlation, but many have failed to deliver on their promises.

They appealed to plans looking to plug funding gaps in a world where enduring low yields on most conventional bonds and equities have led many to look further afield to meet investment requirements.  The global financial crisis of 2007-2008 showed us that many hedge funds were unable to produce the promised risk/reward profiles, and many investors endured serious capital losses. Many hedge funds exemplified headline risk—the very thing plans seek to avoid.  The Credit Suisse Hedge Fund Index reveals an annualized net return of +3.75 percent over the 10 years ended December 31, 2016, well below the +6.75 percent annualized return of the S&P 500 Index.  

Cutting Back the Hedge

But disappointing performance is only one reason why pension plans have been reducing hedge fund exposure recently. The California Public Employees' Retirement System was the first major public pension plan to abandon hedge funds in 2014, but many have followed suit since. Specific issues relate to cost (2 percent fee on assets plus 20 percent on outperformance), complexity, lack of transparency and illiquidity.

Many hedge funds also employ a predetermined asset allocation process derived from quantitative models. Some of these “black-box” strategies mask the rationale behind investment decisions, as well as the assets or risks to which the underlying strategy may be exposed. This opacity became an issue during the global financial crisis when many hedge funds suffered significant capital losses, and investors struggled to access liquidity to fund pressing liabilities.  While there are some good hedge funds still operating, their numbers appear to be dwindling. 

Introducing Liquid Alternatives

Traditional long-only asset managers are filling the gap with multi-asset class strategies, or MACs, sometimes referred to as “liquid alternatives.”  There are four broad categories:

1. Absolute return strategies, offering, for example, LIBOR plus 3-5 percent with target volatility between equities and bonds and relatively low market correlation.
2. Relative return strategies, which offer a 60/40 split of equity and fixed income with a higher risk/return profile.
3. Risk parity strategies, which allocate equally across asset classes based on risk, and employ leverage to boost returns.
4. Risk premia strategies, which use a quantitative-analysis approach to produce low-volatility returns that unearth quality and value, and tend to have the highest risk/return profile.

MACs may appeal to a broad range of institutional clients seeking a return stream with low correlation to risk assets. In contrast to hedge funds, they should be inexpensive, offer daily liquidity and low leverage levels, and should not short individual securities. They should also seek to reduce overall portfolio volatility.  

Transparent security selection, asset flexibility across global markets unconstrained by indices, and a focus on capital preservation are also key requirements.

MACs can be a viable alternative to hedge funds for institutional investors. However, investors should review each MACs category to determine which type best fits their investment requirements.

This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular investment, strategy, investment manager or account arrangement. 

Jon C. Ritz

About the Author:

Jon C. Ritz is head of Institutional, North America Newton Investment Management. He is based in New York.