After 10 years of quantitative easing, we find ourselves in a world very different to the one that existed pre the Global Financial Crisis. Today, it is harder for active investment managers to outperform their benchmarks. Recently, even Warren Buffett acknowledged that he had found it difficult to outperform the S&P 500® Index in the short to medium term.
Exhibit 1: Buffett's annualized alpha
Source: Bloomberg and Datastream. Based on Berkshire Hathaway A shares to 30 August 2019. Janus Henderson makes no representation as to whether any illustration/example mentioned is now or was ever held in any portfolio. Illustrations are only for the limited purpose of analyzing general market or economic conditions and demonstrating the research process. References to specific securities should not be construed as recommendations to buy, sell or hold any security, or as an indication of holdings.
Similarly, many of the best-known hedge fund investors have significantly underperformed the market. Statistical estimates of alpha from the hedge fund industry show returns have trended down in the last 25 years. Estimated one-year alpha currently stands at -2%, as shown in Exhibit 2. A more disturbing development is that more than 90% of variation of returns (the driver of performance) is explained by exposure to the S&P 500. This illustrates that hedge funds as a whole may not be providing the diversification benefits that many investors have historically used them for.
Exhibit 2: Hedge fund industry – lower alpha, reduced diversification
Source: Bloomberg and Datastream. HFRI Fund Weighted Composite Index data to 30 August 2019. Past performance is not a guide to future performance.
This backdrop may account for increased outflows from the hedge fund industry. Data from eVestment shows that investors withdrew around US$56 billion from hedge funds in the first seven months of 2019, the worst start for fundraising since 2016. This was despite the best stretch of performance in a decade, although as noted this was equity beta driven. Clearly, the hedge fund industry is undergoing consolidation and many managers are struggling to deliver alpha. But this does not mean that investors should lose sight of the benefits that alternatives investing can bring.
At Janus Henderson, we invest across a diversified suite of alternative risk premia and hedge fund strategies, rather than relying on equity beta. Over time our strategies aim to realise close to zero net exposure to traditional equity and fixed income markets.
Hedge Fund Research Indices show that an approach based on lower equity beta can prove beneficial. Exhibit 3 shows estimated alphas of hedge funds with equity exposures of less than 25%. Over a five-year period, many of these strategies have delivered reasonable alpha.
Exhibit 3: Alpha generation based on low equity beta strategies
Source: Janus Henderson analysis using Bloomberg and Datastream data on Hedge Fund Research Indices, five years to 30 August 2019. Note: EH = Equity hedge, RV = Relative value. Past performance is not a guide to future performance.
Many low beta strategies have a relative-value or macro investment style. It is reassuring that skill-based investment does still exist and, indeed, as market volatility picks up, investors may start to turn toward alpha and away from equity beta. We believe this move is timely and certain clients are right to consider managers with the potential to deliver returns as well as important diversification benefits to an overall portfolio.