Key Points:
- Alternative investments are experiencing significant growth, with assets under management expected to reach $23 trillion by 2026.
- Private equity funds can manipulate valuations to appear uncorrelated to equities, making them attractive to investors.
- Correlations are essential in alternative investments, but there may be hidden risks beneath the surface.
- Some hedge fund strategies have low correlations to traditional asset classes and may offer diversification benefits.
- Adding alternative strategies to a traditional portfolio did not improve risk-adjusted returns.
- During the global financial crisis, alternative strategies experienced significant drawdowns, undermining their diversification potential.
- Alternative strategies have generally produced poor net returns for investors over the past 19 years.
- Investors should consider correlations during market downturns to identify truly uncorrelated alternative strategies.
Introduction
The alternative investments market has been growing rapidly, with assets under management reaching $13 trillion in 2021. This figure is expected to surpass $23 trillion by 2026, according to Preqin research. Venture capitalists, private equity (PE), and hedge fund managers are currently enjoying prosperous times.
While the year 2022 has been challenging for venture capital and other alternative investments, some fund managers have been able to navigate these difficulties better than others. This is because they can manipulate the valuations of their investments. PE funds, in particular, can smooth out losses over several quarters due to their lack of daily mark-to-market accounting.
Though PE returns may appear uncorrelated to equities on the surface, both asset classes carry similar risk exposures. This ability to appear uncorrelated makes PE investments appealing to investors. However, correlations are like icebergs floating in the sea – there is often much more hidden beneath the surface.
Therefore, it is important to understand the pitfalls of relying solely on correlations when selecting alternative investment strategies.
The Alternative Champions
To analyze the potential diversification benefits of alternative investment strategies, we selected seven well-known strategies from the hedge fund universe. These strategies have attracted billions in capital and have daily return data going back to 2003.
Three of the selected strategies – equity hedge, merger arbitrage, and event-driven – demonstrated correlations to the S&P 500 index higher than 0.5. This indicates that adding these strategies to an equity portfolio would not provide much diversification due to their similar risk profiles.
However, three other strategies exhibited low correlations to both stocks and US investment-grade bonds. These strategies may offer some value for investors seeking diversification.
Quantifying Diversification’s Benefits
In order to test the diversification potential of the selected strategies, we sorted them by their average correlations to stocks and bonds. We then ran simulations that added a 20% allocation to each strategy to a traditional 60/40 equity-bond portfolio, which was rebalanced quarterly.
Contrary to expectations, adding alternative allocations did not improve the risk-adjusted returns (Sharpe ratios) for the period from 2003 to 2022.
Additionally, there was no clear relationship between correlations and Sharpe ratios. Even though merger arbitrage had a higher average correlation to stocks and bonds compared to equity market neutral, adding the latter to the portfolio did not result in a significantly higher Sharpe ratio.
Fair Weather Correlations
One possible explanation for the lack of improvement in risk-adjusted returns is the deceiving nature of correlations. Even if correlations are low on average, they can spike during periods of market turbulence, precisely when investors most desire uncorrelated returns.
For example, merger arbitrage, which is typically uncorrelated to equities, can experience high correlation during stock market crashes when mergers fall apart. Economic cycle risk, inherent in stocks, cannot be negated by constructing a beta-neutral portfolio with long positions in acquirable companies and short positions in acquiring firms.
All seven alternative strategies we analyzed experienced losses during the global financial crisis of 2008-2009. Convertible arbitrage, in particular, performed even worse than equities, despite its supposed diversification potential.
Further Thoughts
Our analysis suggests that correlations alone are not sufficient in identifying alternative strategies with true diversification potential. A more nuanced approach is required, such as measuring correlations during periods of market decline to weed out strategies with inherent economic risk.
It is important to note that many alternative strategies have not generated positive net returns for investors over the past 19 years. While some strategies may generate attractive returns before fees, their net returns have been poor. The average equity market neutral fund, for example, has experienced negative returns of 0.4% per year since 2003.
Investors should also consider the impact of inflation on returns. Strategies with returns below the inflation rate imply negative real returns and may no longer be viable options in today’s higher inflation environment.
Overall, correlations are just one factor to consider when selecting alternative strategies. A broader set of tools and a deeper understanding of the underlying risks and returns are necessary to identify truly diversified alternatives.
