Since the outbreak of Covid-19, asset classes have tumbled globally. Modern portfolio theory always dictates that a well-diversified portfolio should have a mix of asset classes that diversify the risk/return profile over time. However, in periods of market shocks and fast-moving markets on the downside, we see much more auto-correlation between asset classes. That is, they all behave similarly in varying degrees which, in the short term, confounds the diversification principle.
This brings me to how a sample of hedge fund strategies in South Africa behaved during March and the first two weeks of April 2020.
As RisCura’s investment analytics team monitors and reports daily on a large segment of the South African hedge fund market, we’re able to make observations and interpret patterns. Hedge funds, by definition should be an asset class or strategy aimed at hedging out unwanted risk via shorting techniques. They can also leverage and engage in strategies that long-only managers are not typically at liberty to perform.
From our data we see that, depending on the strategy, the returns have varied significantly between managers. Looking at March 2020, the broader equity market as measured by the SWIX Index was down -16.76% where the broader bond market as measured by the ALBI Index was down -13.24%. The volatility for the two asset classes varied significantly where the SWIX volatility was at 14.45% compared to 3% for the ALBI. Ignoring the risk-adjusted returns for the period, both asset classes behaved similarly in a period of shock.
Looking at hedge fund returns – specifically the broadest and largest category which is long/short equity – the weighted average return for March 2020 was -8.45% with approximately 9% volatility. The market-neutral category fared better, with a return of -0.72% and an average volatility of 5%. This in a month where the drawdown in markets was unprecedented and highlights how a market-neutral strategy can be defensive as well as providing diversification from other asset classes.
What really sticks out though is the wide dispersion of returns for this category in March – from +2% for some funds to -40% for others. As expected, the volatility of these funds also varied enormously, highlighting how each portfolio has been constructed and the level of leverage it is deploying. What it also highlights, as we have indicated before, is that selecting a hedge fund manager in the long/short category should be done with a very close eye on the underlying volatility and leverage of the manager, to determine what fit one needs in a broader asset mix. Underpinning this argument is that AUM is not an issue as again, the dispersion of the larger managers varied significantly.
We also ran similar numbers from April 1 to April 21, 2020, which showed a bounce and some form of reversion in returns. The SWIX Index was +7.60% where the ALBI Index was +4.23%. We wanted to establish whether the funds behaved as expected assuming the portfolio construction was maintained; and we saw a weighted average in the long/short space of +5.50% with approximately half the equity volatility. The market-neutral strategies were +2.77% with an average volatility of 6%. As expected, the dispersion of the returns was quite high between the strategies where some long/short strategies were as high as +25% and some managed a negative return for the month.
In summary as we have always said, hedge fund returns should always be risk-adjusted and leverage should be taken into account when looking at the asset class. In times of unprecedented market falls as we’ve recently experienced, several hedge funds in South Africa – and well-known names – held their own. They were diversified through their portfolio construction and investment strategy, which would have acted as a resilient diversifier to one’s multi-asset portfolio.
We believe that hedge funds per se need to be further broken down into risk-adjusted buckets and leverage so that asset owners and asset allocators or investors into these funds can allocate appropriately and know what to expect in different market directions. What also needs to be taken into account is that those funds that diversified were also liquid, which in times of stress and market drawdowns makes them even more attractive to other alternative assets that display very little or no liquidity in times of turmoil.
by George Tsinonis, Head of Investment Analytics at RisCura