How hedge funds can help you ride through market volatility

This post was created in partnership with Endowus Singapore Pte Ltd (“Endowus”). All views and opinions expressed in this article are Beansprout's objective and professional opinions. 

Let’s face it – it is becoming harder to generate a return on our investment portfolio that beats the pace of inflation. 

While the yield on Singapore 6-month T-bill remains decent at above 3.5%, it is hardly sufficient for us to meet our retirement planning needs if we were to allocate our entire portfolios to the government-issued bond. 

The growing concerns about an upcoming global recession have made it even more challenging for investors to time the market and find the right investment opportunities. 

This inevitably led many to ask if there is a way for investors to potentially generate a positive return over any period through the market cycle. 

Hence, we thought it might be worthwhile taking a look at hedge funds. 

A short history on hedge funds 

There’s a mystery surrounding hedge funds, even though they have operated in some form a long time ago, going as far back as the 1940s.

As the name suggests, the first hedge fund performed some form of hedging in equity investments to eliminate certain market risks. By doing so, it was able to significantly outperform other mutual funds. 

One classic hedge fund example was in the 1980s when Julian Robertson’s Tiger Management Fund outperformed the S&P 500 in 14 years between 1980 to 2000. It was able to do so with trades such as shorting copper and betting against the Thai Baht, delivering average annual returns of 25% by the time it returned investors’ capital.

The popularity of hedge funds continued to grow in the years to come, with new hedge fund strategies developed with the objective of delivering better risk-adjusted returns for investors.

What are hedge funds?

In a nutshell, hedge funds are actively managed funds that aim to generate positive absolute returns through ups and downs in the market by using a variety of investment strategies.

These strategies may include using leverage to boost the returns of a certain investment or taking both a long and short position to mitigate risks.

This would differentiate hedge funds from mutual funds, which face more restrictions on the investment strategies they can adopt. 

Hedge funds are also more focused on delivering a positive absolute return, or the return that an asset achieves over a certain period. 

This once again distinguishes hedge funds from mutual funds, which are typically benchmarked against an index or peer group. 

How do hedge funds invest?

To be able to deliver positive absolute returns, hedge funds use a number of different strategies. Some of the commonly used hedged funds strategies would include equity hedge, event-driven, relative value, and macro.

Equity hedge funds employ various strategies, such as long-short equity and market-neutral approaches, to enhance risk-adjusted returns. These funds balance their portfolios by taking long positions in certain assets while shorting others, creating a versatile exposure that aims to capture market inefficiencies and deliver improved performance.

Event-driven hedge funds take trades to exploit any price moves that may occur before or after a corporate event to profit when the predicted event such as an M&A, bankruptcy or earnings call occurs. For example, a hedge fund could take a trade to take advantage of a corporate action that may cause its share price to increase.

Relative value hedge funds capitalise on price discrepancies between related financial instruments. By identifying pairs or groups of instruments with historical correlations, these hedge funds can take both long and short positions to capture potential price movements.

Macro hedge funds employ macroeconomic and political analysis to seize price movements across major assets like equities, bonds, currencies, and commodities. They may utilise both long and short trades to take advantage of macro events and trends to generate returns. 

How have hedge funds performed historically? 

Regardless of the style adopted by the hedge fund, they seem to have demonstrated an ability to deliver better risk-adjusted returns for investors historically. 

This is measured using the Sharpe ratio, which reflects the amount of return on any level of risk taken. When the Sharpe ratio is higher, investors would perceive the returns to be of higher quality.

Hedge funds have offered comparable or higher Sharpe ratios over the past 20 years when compared to a global equities portfolio as well as a 60/40 portfolio of equities and bonds, according to calculations by Mercer.

For example, the Sharpe ratio of the HFRI relative value index and macro index were at 0.9 and 0.7 respectively, exceeding that of the 60/40 portfolio. 

The value of hedge funds becomes more evident when public markets are volatile, as we are seeing right now with significant macroeconomic uncertainty.

As hedge funds pursue niche strategies with unconventional approaches like shorting and leverage, they can help with risk management during periods of sharp market corrections.

The maximum drawdown of various hedge fund strategies has been shown to be lower compared to a 60/40 portfolio and investments in global public equity markets. 

According to calculations by Mercer, the maximum drawdown of the HFRI Macro Index was just 8%, performing better than the 55% drawdown for the MSCI AC World Index. 

Fund of hedge funds offers diversification 

With so many different hedge fund strategies available, how do we decide what is best suited for our portfolio needs?

If you do not want to go through the hassle of selecting a specific hedge fund strategy, a fund of hedge funds can come in to facilitate diversification and improve risk management. 

A fund of hedge funds effectively allocates capital among different hedge fund strategies to meet investor demand for returns while balancing risks. 

This is because each hedge fund strategy is unique and has unique risk-return characteristics that can help to diversify a portfolio.

Moreover, the inclusion of multiple managers allows for more capital to be deployed and mitigates the potential capacity constraints of a single fund. Each fund manager contributes their distinct expertise, investment philosophy, and track record to the overall portfolio.

This comprehensive diversification across strategies and fund managers offers investors a way to navigate market volatility and potentially achieve superior risk-adjusted returns, especially during periods of market uncertainty.

For example, during the dot-com crisis of 2001-2004, composite hedge fund returns measured by the HFRI Fund Weighted Composite Index saw a drawdown of just 6%, compared to a 38% drawdown in the MSCI AC World Index. 

Between Nov 2007 and Mar 2013, a period of market weakness encompassing both the Global Financial Crisis and the European debt crisis, the same hedge fund index saw a drawdown of 21% - again, outperforming the global equity index, which declined by 55%. 

What are the risks of hedge funds?

All investments come with risks, and some of the key ones relating to hedge funds include market risk and liquidity risk.

#1 – Market risk

As all investments come with risks, hedge funds also carry market risks even if the manager may try to mitigate such risks through different hedging strategies. 

In particular, the use of leverage by hedge funds may amplify the performance of assets held. In this case, a small movement in the wrong direction may impact the fund’s returns significantly.

Hence, it is important for investors to be aware of the investment risk relating to hedge funds and select funds which have a strong and proven performance track record. 

#2 – Less liquidity compared to publicly-listed securities

Compared to publicly-traded securities, hedge funds may have monthly or quarterly redemption cycles that only allow investors to redeem their holdings every month or every quarter. 

Furthermore, some hedge funds impose gates and lock-up periods, limiting investors’ ability to withdraw their money or exit from the fund.

As such, you should make sure that the funds invested in the hedge fund are not required to meet any near term liquidity requirements. 

Accessing hedge fund strategies has historically been hard

Despite the benefits that hedge funds can bring to building a diversified portfolio, investing in hedge funds has traditionally been reserved for high net worth private banking or institutional investors. In addition, the minimum investment into a single hedge fund strategy could be as high as US$100,000.

However, with the advent of digital platforms, the high barriers of entry that have made it difficult for investors to access such fund-of-hedge-funds traditionally have been significantly lowered.

Endowus Private Wealth bolsters access to hedge funds with transparent fees

Endowus, Asia’s leading fee-only wealth platform, offers absolute return multi-strategy hedge fund solutions and other alternative investment products to accredited investors. 

If you are an accredited investor and are interested to find out more, please contact privatewealth@endowus.com.

Important Disclaimers

Endowus Alternatives is intended for accredited investors only.   

The information herein is for general information only and does not constitute a recommendation, an offer to sell, or a solicitation to invest in any securities, options, or other derivatives in any jurisdiction and its content is not prescribed by securities laws. This information herein is not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject Endowus or the relevant asset manager to any registration or licensing requirement in such jurisdiction or country.

Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund. 

You should carefully consider whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources, investment eligibility and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

The information and analysis shared here is from Beansprout and not Endowus. Endowus does not give any warranty or representation, either express or implied, and expressly disclaims liability for any errors or omissions. Information may be subject to change without notice. Endowus accepts no liability for any loss, indirect or consequential damages, arising from any use of or reliance on this document. 

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