The recent coronavirus outbreak continues to spread throughout the world, having a significant effect on global economies and markets, as well as our daily lives. While the impact on people is not lost on us, it is our job to evaluate and assess the impacts through the lens of financial markets and investment. The virus has had significant global impacts, and we believe it represents a stark reminder of the merits of sound asset allocation and robust portfolio construction. Preparation for uncertainty, volatility and dislocation gives us some breathing space to formulate a calm, defined and thoughtful response to such events. It is our view that including alternative risk factors and exposures represent one way in which investors can prepare. Hedge funds have a role to play.
From their respective peaks/lows earlier this year, global equities have fallen 27%, oil markets (exacerbated by an all-out price war between Russian and Saudi Arabia) have declined 57%, 10-year U.S. Treasury yields have declined more than 1% to 0.73% and volatility is up more than 5 times. Importantly, the traditional risk premia that dominate portfolio risks and as a result, investor portfolios, have been whipsawed while investors sort out the short- and potential longer-term impacts on the economy.
For Mercer, peace of mind comes from preparation, and specifically, from the inclusion of a collection of non-traditional risk exposures, which are diversifying, complementary and can benefit from periods of uncertainty. Specifically, it is our view that an optimal approach to access alternatives includes a long-term strategic allocation to unconstrained hedge funds.
Traditional risk premia are those that, generally speaking, can be achieved with exposure to traditional asset classes, namely equity and fixed income. Equities are included in portfolios to participate in global economic growth and provide relatively strong long-term returns. Traditionally, fixed income securities were included in portfolios to dampen the volatility of equities and provide a safe haven during substantial market declines. However, results of both asset classes are driven by the direction of markets and interest rates. Identifying and capturing other sources of risk and return can result in a portfolio which is less reliant on direction and sentiment, often referred to as “alpha.”
Mercer takes the view that an optimally constructed portfolio of hedge funds relies on skillfully managed active exposures that produce attractive risk-adjusted returns with minimal dependence on market risk. The value proposition for hedge funds stems from their unconstrained structure and broad opportunity set. Hedge fund managers may utilize a wide range of investment approaches to generate differentiated return profiles through active management while minimizing the impact of broader capital markets. The hedge fund manager’s toolkit is therefore broader than that of traditional active managers. Hedge funds have a greater degree of freedom to make use of bi-directional investing (shorting), leverage, derivatives, private investments, increased concentration and varying time horizons for example. These tools allow managers draw on their skills and experience to isolate specific risks and provide multiple avenues to add value via the hedging of unwanted risks and the exploitation of non-traditional risks. This latter category includes security selection (isolated via bi-directional investing and concentration), market timing, deal risk (e.g., merger arbitrage), process risk (e.g., distressed/activist investing), complexity risk, spread risks (e.g., capital structure arbitrage) and liquidity provision (during periods of market stress) to name just a few.
One key trait of many of these alternative risks is that they are opportunistic. The hedge fund hunting ground is one largely focused on dislocation, misinterpretation and areas of neglect or avoidance. This allows these strategies to serve as the middle ground between public and private markets or areas of temporary inefficiencies as asset prices reset and underlying investor bases change. Alternative risks at times may be no less sophisticated than time arbitrage — taking a longer-term view, being nimble and exercising patience. Hedge funds stand ready to provide liquidity to those that may be forced to sell for uneconomic reasons, often as a result of fear and panic. We believe this is critical in today’s environment. Coronavirus is just one concern on investors’ minds. Geopolitical risks and climate change also continue to weigh on investors’ minds and add to uncertainty.
As we have described, nontraditional risks can add diversification, lower market dependence and thereby result in a lower risk portfolio — particularly in terms of drawdowns.
Source: Thomson Reuters Datastream and Mercer, as at March 20, 2020. Indexes used are MSCI All Countries World Index (global equities) as reported by MSCI and HFRI Fund of Funds Composite (hedge funds) as reported by Hedge Fund Research Inc. Period shown is from January 31, 1990, to March 16, 2020 for global equities and from January 31, 1990, to February 23, 2020 for hedge funds.
Importantly, this risk reduction does not necessarily come at the cost of lower returns, making for a compelling stand-alone and complementary risk/reward proposition and efficient use of capital. The results shown in the graph below reflect the average hedge fund experience based on an index, but the universe offers flexibility to tailor risk and return across the spectrum through manager selection and portfolio construction.
Source: Thomson Reuters Datastream and Mercer as at March 20, 2020. “Broad fixed income” reflects the performance of the Bloomberg Barclays Global Aggregate Bond Index, formerly known as the Lehman Aggregate Index, “Global equities” reflects the performance of the MSCI All Countries World Index as reported by MSCI and “Hedge funds” reflects the performance of the HFRI Fund of Funds Composite as reported by Hedge Fund Research Inc. net of fees. Past performance is not indicative of future results. Returns and standard deviations beyond one year are annualized. Period shown is from January 31, 1990, to February 29, 2020. Please refer to Important Notices at the end of the presentation for additional information.
However, a hedge fund allocation requires a long-term strategic commitment or at the very least a full market cycle to fully assess its benefits.
To be clear, most hedge funds are not hedged to specific market shocks and therefore are not completely immune from global concerns over the coronavirus or other uncertainties that might be swiftly (and dramatically) reflected in asset prices. This means careful portfolio construction, and risk diversification, can be crucial to success.
Coronavirus aside, we see a number of excesses, and a lot of uncertainty in key areas of the market with potential long-term impacts on portfolios. It is in the aftermath of excess, and in periods of turbulence, that we expect hedge funds to add the most value. We believe that hedge funds represent the fullest expression of alternative diversification and active management to capitalize on idiosyncratic opportunities.
 All data as at March 17, 2020 and sourced from Thomson Reuters Datastream and the Federal Reserve. Indexes used are MSCI All Countries World Index (global equities), Crude Oil: Brent (oil), Federal Reserve 10-Year Treasury Constant Maturity Rate (U.S. Treasury yields), CBOE Volatility VIX Index (volatility).