Asia-based investors in private client investment strategies may be wishing that they had simply invested in their local stock market this year. Pacific stock markets have outperformed all other regions and asset classes in 2004 so far. The Hang Seng and the MSCI Asia Pacific ex-Japan indices are both posting returns of over 6% year-to-date, compared to a return of under 3% from the MSCI World Index and under 2% from the Citigroup World Government bond index. Hedge funds, one of the best-performing and fastest growing asset classes in recent years, are down -0.55% (as measured by the HFR Equal Weighted Strategies index).
No one likes to see their investments lose money, especially if they have only recently made the decision to invest in a particular strategy or asset class. In analysing the performance of private client investment strategies this year, particularly absolute return strategies that tend to have a high allocation to hedge funds, investors must ensure that they understand the long-term objectives of the strategy in which they are invested and view recent performance within the context of an optimal investment time horizon of perhaps three to five years. While the Asian markets may look like a missed opportunity this year, the simple performance figure masks considerable intra-month volatility; while the highs have been higher than those of other regions, the lows have been much lower too, with the MSCI AC Asia Pacific ex Japan index at one point down nearly 20%1.
Outperformance of Asian markets
Year-to-date (and underperformance of hedge funds)
31 December 2003 - 30 September 2004
Performance of Private Client Investment Strategies
Private client investment strategies can be broadly divided into traditional, relative return strategies - whose performance is measured against a benchmark such as an equity index or a blended equity, bond and cash index - and absolute return strategies that have no set benchmark or investment parameters. These strategies instead aim to achieve capital preservation in difficult market conditions and growth over the long term. While investors in relative return investment strategies take a long-term view of markets and must be willing to accept a higher degree of market volatility for the performance this can deliver, absolute return strategies can be thought of as an investment "cure-all". This year, a number of variables have coincided to create a difficult trading environment for the range of asset classes in which absolute return strategies invest. This, in turn, has impacted returns for the overall strategy. Below we provide our analysis of events and what may be in store for 2005.
Absolute Return Strategies
Theoretically, between 0% and 100% of absolute return strategies can be invested across any of the asset classes available to the portfolio manager. These asset classes include both the traditional (equities, bonds and cash) and the alternative (hedge funds). Absolute return strategies tend to have a higher allocation to hedge funds than relative return strategies. Since 2000, investors in absolute return strategies have been spared the vast majority of the losses that equity markets have experienced and in many cases are looking at good positive returns over that period. However, the downside protection that these strategies have delivered has perhaps given investors the impression that these strategies can withstand any difficult market environment.
2004 has presented financial markets with a unique set of variables which caused the correlation between various hedge fund strategies and equities and bonds to rise and therefore there have been periods this year of synchronised falls across asset classes.
The poorer performance of hedge funds this year in comparison to their historic returns has been particularly well-publicised. Generally, hedge fund strategies require one or more of the following variables to be in place in order to outperform; volatility, trends, fluid market volumes (liquidity) or market dislocations (usually macroeconomic or politically-driven). At the start of 2004, it was anticipated that there would be volatility, as had prevailed since 1998; trends, particularly in fixed income and currencies; volume, especially in equities as investor risk appetite had displayed signs of improvement; and the possibility of market dislocations as a result of both geopolitical and local political events. However, as we now know, that is not how the year evolved.
The hedge fund universe consists of a wide range of strategies and sub-strategies whose performance has varied considerably this year. We feel that there are sufficient similarities between strategies in terms of risk and return to group hedge funds into three broad segments; equity long/short, trading and relative value, in order to facilitate asset allocation.
Synchronised falls across asset classes in 2004
27 February 2004 - 16 May 2004
Equity long/short strategies can be viewed as a style of equity investment and used within client portfolios to provide added flexibility within the equity allocation, particularly assisting with protecting returns during falling equity markets. This strategy, according to HFR figures, is down -0.88% year-to-date (HFR Equity Hedge index) while the MSCI World index is up 2.85%. During the second quarter of this year, equity hedge managers typically lost money due to their net long bias, the significant rise in correlation between individual stocks and also as a result of the volatility of performance between small and large-cap stocks. The market volatility caused a number of managers to reduce their gross exposure early in May, which resulted in them not participating fully in the ensuing market bounce. It is encouraging to note that third quarter performance appears to have been stronger, with managers posting positive returns while the MSCI World index ended the third quarter down. In particular, global equity long/short managers performed strongly while Japan-focused managers were weaker. Going forward, the equity markets seem to have priced in many of the risks and concerns of the second quarter such as the oil price and security. Those managers who have achieved a positive return for the year so far can remain engaged in the markets, which should allow them to capture opportunities quickly as they emerge.
Trading strategies encompass a range of investment approaches focused on financial instruments such as currencies, fixed income, commodities and equity derivatives. What they typically have in common is non-correlation with traditional markets such as equities and bonds. Trading managers merit an allocation within an absolute return investment strategy for two reasons. Firstly, correlation between trading managers is usually low, given the variety of styles and markets covered and secondly, their low correlation with equity-focused managers provides an additional source of returns in falling equity markets.
Trading managers as a whole tend to need volatility, trends, market dislocations or liquidity in order to make money. These factors have been absent during the second and third quarters of this year. We believe it is unlikely that there will be a continued absence of the factors that these managers need in order to perform. One reason for this is that significant dislocations in policy are developing. These could begin to come to fruition after the US elections as the next government and markets face up to the imbalances. If this occurs then there are likely to be multi-year opportunities both in fixed income and in currency markets. Relative value hedge fund strategies can be characterised as those that derive performance from exploiting the mis-valuation of one security versus another and includes strategies such as arbitrage. In normal market conditions, the correlation of these strategies with equity and bond markets is low, so, in general, relative value funds bring portfolio diversification benefits. Arbitrage strategies for example, have made a little money this year, compared to other strategies which are in negative territory. The best performing strategies have typically been the most illiquid, such as those focused on distressed investing, and highly leveraged, such as those focused on mortgage-backed securities.
While hedge funds do play an important role within absolute return investment strategies, it is their combination with other asset classes such as equities, bonds and cash that enables the strategy to preserve capital and deliver long-term growth. In 2004, the variables that have contributed to a difficult market environment for hedge funds have also adversely affected traditional asset classes such as equities and bonds. Low or negative correlation between the various asset classes in which absolute return strategies tend to invest has been beneficial in falling markets historically. It is the absence of this characteristic which makes this year unusual and which has caused performance to suffer.
Absolute return strategies provide downside protection
31 December 1999 - 31 August 2004
At GAM, we anticipate that markets will ultimately return to their more normal behaviour and we continue to believe that actively managed allocations across a range of asset classes and regions should not be abandoned. In our absolute return strategies we intend to maintain a diversified investment approach as we go into 2005. We believe a degree of caution is warranted regarding equities. While equity markets could rally over the short term, particularly if oil prices weaken, we do not anticipate a permanent upward shift. Our strategy currently includes high weightings to equity long/short strategies and alternative investments. If markets do trend sideways for some time, a strategy such as equity long/short that can participate from both rising and falling stock prices should prove effective. In terms of trading strategies, while recent performance has been disappointing we believe that this is a short-term reversal associated with unusual market conditions.
We believe that the long-term investment dynamics between asset classes are more robust than the short-term relationships suggest. In particular, there is no evidence to suggest that the long-term performance characteristics of the asset classes in which absolute return strategies invest, or importantly, their correlation with each other, have changed. The short term is invariably a poor predictor of longer-term dynamics.
1 The performance of the MSCI AC Asia Pacific ex Japan index between 12 April 2004 and 17 May 2004 was -17.76%
