Downturn highlights value of non-correlation

The hedge fund industry is facing the most serious challenge in its history, due in no small part to the fact that many funds that marketed themselves as so-called alternative assets have fallen just as fast, and just as hard, as plain vanilla equity funds. But there are some mandates offering non-correlated performance.

Anyone invested in a hedge fund for returns rather than for correlation is most likely disappointed. Given market conditions, where only one asset class — government bonds — has shown positive performance, it’s hard to expect an absolute return or long/short equity mandate to deliver any type of eye-popping positive performance — in fact, it would be surprising to see even well-managed mandates deliver positive performance, period.

Carving out a portion of a portfolio for exposure to alternative asset classes is a basic tenet of modern portfolio theory. The goal is to find assets that have positive long-term returns, preferably posting positive returns during a total market downturn, thus blunting portfolio losses. There is the perception that hedge funds have not done this during the market crash.

“Hedge funds are unfairly painted with a broad brush much the way mutual funds are. Many funds have not done well in the last 12 months and for others that is not the case,” says Richard Foerster, a portfolio management expert and professor of finance at the Richard Ivey School of Business at the University of Western Ontario. “What’s not done well in the hedge fund realm is anything that was involved in long positions in equities. Long/short strategies do tend to be weighted on the long side of equities. It’s only when you get something like a pure market-neutral strategy that you truly should have low correlation. Then you’re really betting on the manager’s skill to find relative value.”

Market neutral funds have performed relatively well, notes Chris Holt, a hedge fund industry commentator and editor of AllAboutAlpha.com. Holt notes that the market-neutral equity indices were generally flat in 2008. Meanwhile many of the major hedge indices — including long equity mandates — were down significantly, but nowhere near the losses sustained by global stock indexes.

The Eureka Hedge Fund index was down 12% last year, and the Credit Suisse Tremont index was down 18%, but Holt says these “pale in comparison” to the MCSI index, which was down 42%.

“This notion that hedge funds should have been hedged and weren’t because they were down, I think, is muddled,” he says. “The indices that are reported in the media include a lot of directionally-biased sub-indices and funds. If a fund had a positive market exposure and went down with the market, no one should be particularly surprised with that performance. Global macro-strategies are doing well; managed futures are doing well; market-neutral equity has been flat.”

The challenge for advisors is to find mandates that truly bring non-correlated returns to the portfolio. Foerster notes that 2008 returns could be a good benchmark to discover which mandates have managed to deliver non-correlated returns.

“I think you want to investigate [potential investments] over a so-called cycle, because one would expect that if traditional asset classes like equities are doing well — if it really is truly providing a good hedge — you wouldn’t expect as strong a return during bull markets,” he says. “The key test is a market environment like 2008, where, if a non-correlated mandate is truly doing the work it should’ve been, then it should have been providing some positive returns when equities were down.”

There are alternative mandates that have done this. For example, Man Investments’ AHL Diversified Fund is a managed futures program that has produced impressive returns during the latest down cycle. Like most alternative strategies, it’s currently only available to accredited investors and has had periods of volatility, but over time the fund has had positive returns. More importantly, notes Toreigh Stuart, the CEO of Man Investments Canada, it’s had non-correlated positive returns during the worst of this downswing.

“In the last three months, the Man AHL Diversified (Canada) Fund, Class A units, are up 22.4% from October 1 to December 31 — finishing the year up 26.5%. Since July 1, 2007, the product is up 32.4% — that’s the last 18 months of this current bear market,” he says.

Stuart attributes much of the performance to the fund’s focus on managed futures. Over 18 years of the mandate, it’s proven to have very close to no correlation to any other major assets.

“Advisors looking to reduce their clients’ portfolio volatility have often looked towards the use of hedge funds for this purpose,” Stuart says. “I think that’s why advisors have generally been looking to allocate to hedge funds over time. That’s a big argument we make to our clients, and I think it’s one of the biggest reasons why we get investors who are interested in our products.”

Foerster emphasizes that alternative asset classes should probably not exceed 20% of a portfolio — and even that should be divided among mandates. As global markets become more integrated, it’s going to become increasingly difficult to find sources of non-correlation.

“It’s important to point out that, while correlations certainly among developed markets have been increasing over the last couple of decades, we still don’t have perfect positive correlations,” he says. “You’re still going to get some benefits, although the benefits may not be as great as they would have been in past decades. One has to keep looking, to broaden one’s horizons, at asset classes like emerging markets, which still have reasonably low correlation.

“That being said, when there are major global financial events such as happened in 2008, there really are few places to hide.”

(01/29/09)