By Robin Powell, editorial consultant to Sparrows Capital

 

 

“The four most dangerous words in investing,” the famous investor Sir John Templeton once said, “are ‘this time it’s different’.”

 

Again and again, investors who have assumed that things were different at any one point in time, and changed their strategy accordingly, have paid the price.

 

The obvious example is active investing. There’ve been constant assertions over the years that active was about to make a comeback; but investors who heeded the advice of Charley Ellis, Burton Malkiel and others in the 1970s, invested in equity index funds, and stuck with it, have outperformed the vast majority of active investors. Those who tilted their portfolios towards the risk premia identified by the likes of Fama and French — principally size, value, quality, profitability, momentum and low-volatility — have done even better over the long term.

 

Like Sparrows Capital, I’m a staunch advocate of disciplined, low-cost, systematic investing. But, to play devil’s advocate for a moment, what if the situation we find ourselves in today really is different? What if systematic factor investing is no longer optimal in the investing environment we face today? And if that is the case, should investors now be looking, as many are suggesting, to alternative asset classes such as hedge funds?

 

We’re in a new era

 

In answer to the first question, there are two respects in which we genuinely are in a new era. Firstly, investment returns in the future are likely to be lower than they have been in the past. This is down to the gradual re-rating of equities over the last century and reflects, at least in part, reduced investment risk.

 

As Dimson, Marsh and Staunton, authors of the classic book, Triumph of the Optimists, explained in the 2013 edition of the Credit Suisse Global Investment Returns Yearbook, investing is essentially less risky than it was, say, in 1900. Over the last century, “new industries emerged, diversified closed and open-ended funds appeared, liquidity and risk management improved, and institutions and wealthy individuals invested globally. As equity risk became more diversifiable, the required risk premium is likely to have fallen.”

 

Although the financial markets have been treading water for the last two years, recent decades have seen ever-increasing valuations and realised returns, with falling yields.

 

This trend has been accentuated since 2008 through the policies of central banks, particularly very low interest rates and Quantitative Easing. This resulted in a long-drawn-out “everything rally”, in which the value of most financial assets rose. So, in a sense, lower yields and higher asset prices have brought forward future returns and that couldn’t continue indefinitely. Consequently, we are probably entering payback time for the windfall gains that we’ve enjoyed for so long.

 

The second respect in which the present really does differ from the past is that we are now in a higher-inflation world. Inflation ran at historically low levels for many years. That changed dramatically at the start of 2022, not least as a result of the war in Ukraine. Since then, inflation has risen across the globe, with the UK one of the worst hit of all developed nations.

 

So we face, if you like, a double whammy. Just when we need to earn higher returns simply to beat inflation, expected market returns are about as low as they have ever been in living memory.

 

It’s no wonder, then, that we are seeing repeated claims from the asset management industry that the current climate calls for new approaches — particularly unconstrained, high-conviction active strategies like those used by hedge funds.

 

The arguments for hedge funds

 

What are the arguments being made for investing in hedge funds now?

 

A common view is that hedge funds provide a degree of protection against inflation. According to Société Générale, “hedge funds are dynamically arbitraging inflation. Surging inflation… helps hedge funds remain resilient (and) usually outperform traditional assets, thanks to uneven strategies’ sensitivity to inflation. They then tend to perform even better when inflation normalises.”

 

A second argument in favour of hedge funds is that the world has arguably entered a prolonged period of elevated macro-economic volatility. According to a recent note from Goldman Sachs, this increased volatility should lead to better investing opportunities for hedge funds. “Historically,” the authors claim, “when equity and fixed income volatility has increased, hedge fund alpha generation has also improved.”

 

Goldman Sachs suggests several reasons why this might be. For example, it says, when short-term cash instruments offer materially higher interest rates, it creates a “total return tailwind” for hedge funds, which typically have large cash holdings.

 

It also says that the new macro-economic environment benefits the trend-following and directional macro strategies that many hedge funds favour. “We expect the environment to remain attractive for tactical trading funds in the medium term,” the authors state, “particularly for global macro managers.”

 

A third argument for hedge funds is that they act as a diversifier. According to SocGen, “The menu of diversifying assets is limited (but) hedge funds look particularly appealing. (They) show little sensitivity to traditional assets… With an adequate rotation of strategies along the economic cycle, hedge funds provide durable diversification.”

 

The counter arguments

 

There are no obvious arguments against investing in hedge funds in a high-inflation, low-return environment specifically, but the case against using them in general is strong.

 

First of all, even though some funds have moved away from the traditional two-and-twenty charging structure, hedge funds generally remain very expensive. Fees are a significant drag on investment performance and. empirically, the less you pay to invest, the higher your returns are likely to be. Yes, hedge funds offer the potential for outperformance, but to make it worth investing in them at all, the alpha they generate has to exceed the costs entailed. In the vast majority of cases, the fees they charge present too big a hurdle for hedge fund managers to overcome.

 

Secondly, and partly because of their higher expense ratios, hedge funds have consistently produced disappointing returns, particularly since the global financial crisis. According to Aurum, an investment consultancy specialising in alternative investments, hedge fund performance in the five-year period to the end of June 2023 stood at a cumulative abnormal return (CAR) of +4.7%. Although that put hedge funds comfortably ahead of bonds, which were down 1.3% over the same period in US dollar terms, they still lagged equities, which had a CAR of +5.6%.

 

A third main reason for being wary of hedge funds is the additional tail risk they entail. Yes, you could win big if a hedge fund’s bets pay off, but, by the same token, you could also suffer large losses. Hedge funds whose strategies involve the use of leverage and derivatives to trade securities are particularly vulnerable to short, sharp shocks.

 

The 25th anniversary of the collapse of Long-Term Capital Management has put the spotlight on that particular fund in recent weeks, but several other hedge funds have failed as well, including Amaranth Advisors, Tiger Funds and Marin Capital. There are bound to be more failures in future.

 

Fast pain or slow pain

 

As we’ve seen, there are arguments for and against using hedge funds. My own strong preference, as stated earlier, is for systematic indexing over any form of discretionary active management. But every investor is different.

 

As the behavioural finance expert Meir Statman has explained, there are all sorts of reasons why people invest in particular things; some, for example, may choose to invest in a hedge fund for a sense of excitement or may even see it as a status symbol. A more pressing reason why investors may be attracted to hedge funds is that, for whatever reason, they need to take more risk. The right solution is certainly not the same for everyone.

 

Informed investors in search of helpful perspectives on this issue may want to to read Investing Amid Low Expected Returns by Antti Ilmanen. The book’s rather sobering bottom line is that all investors today should brace themselves for pain. Generating the sort of returns we’ve grown used to is going to be very much harder in future.

 

Investors, suggests Ilmanen, can do one of two things in response: either they take more risk or they can carry on as they have been doing and simply accept the likelihood of lower future returns. Either route will be painful; you just have to choose between what the author calls short pain and long pain.

 

For some investors, the short pain option may involve some exposure to hedge funds. If you can identify in advance the right fund manager — and that’s a very big if — you may be able to hit your goals in spite of the low-return environment.

 

The alternative is to not to increase your risk, but to focus instead on factors within your control — particularly cost, diversification and discipline. Get those things right, and your chances of outperforming the great majority of investors are very high.

 

I know which option appeals more to me!