Defined Benefit Plans and Hedge Funds: Enhancing Returns and Managing Volatility
By introducing a hedge fund allocation to their portfolios, DB plans may be able to reduce volatility and increase downside protection.
In recent times, hedge funds have come under criticism because of their under performance relative to the broader equity markets. In the first quarter of 2013, the major hedge fundstrategies—equity hedge, relative value, event driven and global macro—lagged the S&P 500 Index by an average of 7 percent (see figure 1). In the aggregate, hedge funds trailed the S&P 500Index by 6.74 percent during the quarter.1
That pattern was not limited tithe first quarter of 2013. The HFRI Fund Weighted Composite Index underperformed the S&P 500 Index by nearly 5 percent annually from 2010through 2012 (see figure 2). This pattern reflects the run-up in equity markets as they rebounded from their post-crisis lows, receding tail risk as the sovereign crisis in Europe eased and gradual improvements in economic data.
Over a longer period, however, a different picture emerges. During the 16 years from 1997 through 2012, hedge funds delivered superior cumulative returns to domestic and international equities, commodities and fixed income by substantial margins (see figure 3).
During that same 16-year period, each of the major hedge fund strategy indices delivered higher annualized returns than the S&P 500 (see figure 4). In fact, over that time, hedge funds delivered superior annualized returns in comparison to conventional asset classes, including equities (see figure 5).
Increasing returns with hedge fund allocations
Accordingly, adding a hedge fund allocation to a hypothetical portfolio consisting of 60 percent equities and 40 percent bonds would have meaningfully increased returns during those 16 years (see figure 6). A 25 percent hedge fund allocation would have increased the portfolio's annualized returns by 0.53 percent; adding a 50 percent allocation to the portfolio would have increased its annualized returns by 1.08 percent; and reducing the 60 percent/40 percent equities/bonds allocation to 25 percent of the portfolio while increasing the hedge fund allocation to 75 percent would have increased the portfolio’s annual returns by 1.64 percent. A portfolio comprised solely of hedge funds would have higher annualized returns of 2.21 percent.
Many pension plans understandably are focused primarily on hedge fund performance in the years subsequent to the financial crisis, believing the industry has changed fundamentally as a result of stricter oversight and increased conservatism among managers.
Accordingly, the remainder of this analysis centers largely on the post crisis period.
During that time, from 2009 through 2012, introducing a hedge fund allocation to the hypothetical portfolio comprised 60 percent of equities and 40 percent of bonds would not have been additive. Adding a 25 percent hedge fund allocation to the portfolio would have reduced its annualized returns by -0.24 percent; adding a 50 percent allocation to the portfolio would have decreased its annual returns by -0.48 percent; and reducing the 60 percent/40 percent equities/ bonds allocation to 25 percent of the portfolio while increasing the hedge fund allocation to 75 percent would have reduced the portfolio's annual returns by -0.72 percent. These results are partly the consequence of equities having rallied from their post-crisis nadir along with current central bank easing, which has pushed investors into riskier assets such as equities as they search for yield.
However, hedge funds still delivered superior risk-adjusted returns over the same time period with higher Sharpe ratios, lower volatility and steadier rates of compounding.
It should be noted, also, that over time hedge funds are able to avoid sharp drawdowns because, unlike conventional asset classes, they have an asymmetric return profile. This means they capture upside in rising markets, albeit to a lesser extent than equities, but they have smaller losses than equities during market declines (see figure 7). Hence, from 2009 through 2012, equities outperformed hedge funds by 2.3 percent on average when the market was up but were down by an average of -3.2 percent in excess of hedge funds when the market declined. Stated differently, hedge funds captured 41 percent of the upside during months when equity markets showed positive returns but only 29 percent of downside during months when equity markets produced negative returns.
Historic data show that hedge funds offer investors lower volatility than long-only managers4 at different points in the market cycle and provide greater downside protection during times of stress. In 2012, for instance, the S&P500 Index had 11 percent volatility in 2012 as measured by the standard deviation, whereas hedge fund volatility was only 5 percent. Moreover, while the S&P 500 experienced a maximum month-to-month drawdown of -6.3 percent in 2012, hedge funds recorded a maximum month-to-month drawdown of only -2.6 percent.
A similar pattern holds true during the years since the financial crisis. From 2009 through 2012, hedge funds delivered consistently less volatility than equities and provided greater downside protection to mitigate losses. Further, hedge funds had a maximum month-to-month drawdown of -3.9 percent as compared with -11.0 percent for the S&P 500.
Historic data suggests that hedge funds also provide investors with greater downside protection during acute periods of market stress. For instance, from September 2008 through February 2009, the period surrounding the collapse of Lehman Brothers, the S&P 500 Index had a maximum month-to-month drawdown of -16.9 percent. Hedge funds, by contrast, had a maximum month-to-month drawdown of -6.8 percent (see figure 8).
Moreover, throughout that period, during which the VIX monthly average was 43.77, the monthly volatility of the S&P 500 was 19.19 percent whereas hedge funds had month-over-month volatility of only 9.21 percent.
Similarly, from July through October of 2011, amidst the U.S. downgrade and the EU debt crisis, the S&P 500 and the HFRI Fund Weighted Composite had maximum month-to-month drawdowns of -7.18 percent and -3.89 percent, respectively (see figure 9). Hedge fund volatility (5.79 percent) was again materially lower than equity volatility (17.79 percent).
Managing volatility with hedge fund allocations
Because hedge funds provide stable returns on a relative basis, investors can use hedge fund allocations to reduce the volatility of their overall portfolios. As figure 10 demonstrates, adding hedge funds to a hypothetical equity portfolio would have meaningfully reduced its volatility during the period from 2009 through 2012. Adding a 25 percent hedge fund allocation to a hypothetical 60 percent/40 percent equities/bonds portfolio would have reduced its month-over-month volatility by -1.11percent; reducing the 60 percent/40percent portion to 50 percent while raising the hedge fund allocation to50 percent would have decreased volatility by -2.06 percent; reducing the60 percent/40 percent allocation to 25percent while raising the hedge fund allocation to 75 percent would have decreased monthly volatility by -2.81percent; and a portfolio comprised solely of hedge funds would have had-3.29 percent less volatility.
Over time, lower volatility along with downside protection may allow for fewer and less pronounced interruptions to the rate at which a portfolio compounds. In sum, hedge funds can help pensions to achieve "steadier state" investing.
With stable returns and low volatility, hedge funds have produced an attractive risk-return profile over time. As figure 11 illustrates, introducing a hedge fund allocation to a hypothetical portfolio consisting initially of 60 percent/40 percent equities and bonds not only curtails volatility but also adds incrementally to returns.
Given their risk-return profile, hedge funds have yielded superior overall Sharpe ratios to equities in the years subsequent to the financial crisis. Over that period, hedge funds had higher Sharpe ratios than equities in two of the four years while equities had superior Sharpe ratios during the other two years. During that time, though, hedge funds had an average Sharpe ratio of 0.89 compared with 0.58 for equities. Over a longer horizon, from 1997 through 2012, hedge funds delivered higher Sharpe ratios than equities 68.8 percent of the time. During that extended period, hedge funds had a Sharpe ratio of 0.9 versus 0.3 for equities.
Enhancing investment returns
Institutional investors face the twin pressures of needing returns while avoiding significant volatility. Pensions are therefore under pressure to target investments that can meet their targeted rates of return without taking undue risk. Hedge funds certainly offer no silver bullets but they may be able to help pension plans enhance investment returns over the intermediate and long term. Additionally, by introducing a hedge fund allocation to their portfolios, Deplanes may be able to reduce volatility and increase downside protection. Less volatility and smaller drawdowns will meaningfully boost the rate at which pensions' portfolios compound. Over time, hedge funds can enable pensions to increase the risk-return profile of their portfolios. Steadier compounding will better prepare pension plans to meet their funding obligations to current and future retirees.
1 As measured according to the HFRI Fund Weighted Composite Index.
2 HFRI Equity Hedge Index, HFRI Event Driven Index, HFRI Relative Value index and HFRI Macro (Total) Index.
3 It should be noted that the capture ratio averages shown in figure 7 do not include short bias or the HFRI Composite.