Hexit: Is Now the Time to Pull Out of Hedge Funds?
As the trickle of announcements about institutional investors exiting hedge funds became a steady stream, MPI decided to explore whether performance really justified an apparent growing disillusionment. Whereas much analysis and commentary to date had focused on the recent failure of hedge funds to beat the S&P 500 and other equity benchmarks, in our research we wanted to find out whether hedge funds had failed on their own terms.
As the trickle of announcements about institutional investors exiting hedge funds became a steady stream, MPI decided to explore whether performance really justified an apparent growing disillusionment. Whereas much analysis and commentary to date had focused on the recent failure of hedge funds to beat the S&P 500 and other equity benchmarks, in our research we wanted to find out whether hedge funds had failed on their own terms.
Hedge funds are not designed to outperform equity markets during protracted equity market rallies. They aim at capital preservation, volatility reduction, improving diversification within a portfolio and typically deliver superior long-term risk-adjusted returns. To examine whether hedge funds are still doing these jobs, we assessed the benefits of including hedge funds in a broad portfolio of stocks, bonds and cash by running a number of established proxies through MPI’s asset allocation tool. For investment constraints, we assumed long-only positions with maximum allocations for bonds, stocks and hedge funds of 60%, 80% and 25%, respectively. We also included a 60/40 equity/bond portfolio blend as a further reference point, as well as mapping the point with the highest Sharpe Ratio.
For comparison, we created our ex-post optimal asset allocations based on three historical equity market experiences, the first (January 2003-June 2009), corresponding to the equity market rally ending with the 2008 crisis, the second (January 2003-April 2016) including the full period on the two bull runs punctuated by the crisis, and the third covering just July 2009- April 2016 bull market.
The charts below reflect annualized values: the blue line represents an efficient frontier where allocations to hedge funds are allowed (and capped at 25%), while the red line is for the traditional portfolio with allocations only to cash, bond and equity. In the first two cases, allocations to hedge funds would have (in retrospect) improved portfolio efficiency for any risk tolerance level. Even for the period dominated by market rallies (2003-2016), hedge funds can still provide diversification benefits, although the effect on efficiency improvement is not as significant as in the first case.
In the third example, where optimization inputs include only the most recent market rally, allocations to hedge funds have not provided any sizable efficiency benefits to portfolios with generic assets. This would appear to support the views of those advocating lower hedge fund allocations, citing recent market performance. But as our analysis shows, as soon as you take a period of significant market turbulence into consideration, a significant hedge fund allocation becomes worthwhile.
Certain caveats notwithstanding, our analysis suggests investors should carefully consider the role of hedge funds in their portfolio overall and certainly in different market environments before making any hasty decisions to exit from hedge funds. We recognize of course that this is not the whole story. There are other reasons for exiting hedge funds (higher fees, less transparency, illiquidity, etc.), and all hedge funds are not created equal, which is why we will examine the impact of fund selection on overall portfolio efficiency in a follow-up research paper.