Are the Capital Markets Headed for a Major Correction and Will Hedge Funds Help or Hurt?

Don A. Steinbrugge, CFA

Major corrections in the capital markets are a risk that investors must always consider. Experience shows the question is not if a major correction will happen, but when. The challenge for investors is to determine and prepare for the timing, magnitude and longevity of an inevitable correction. Responsible risk management requires investors to consider whether they are properly positioned and prepared to ride out the storm when the correction happens.

Events of the past couple of decades have led investors to expect markets to rebound quickly from a major correction. Seemingly forgotten is the worst sell-off of the US stock market, which began in 1929 and resulted in a decline of almost 90%. It took 23 years to recover. For those tempted to dismiss this as outdated data, take note that the Nikkei index hit an all-time high of approximately 39,000 in 1989. More than 26 years later it is still below half its peak.

Has the probability of a major sell-off increased?

We have recently heard some of the top investors in the world share very negative comments on their outlook for the capital markets. Jeffrey Gundlach speaking with Business Insider stated, “The artist Christopher Wool has a word painting: ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good.” Bill Gross tweeted: “Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.”

With sovereign interest rates hovering at record lows, many investment professionals believe we are experiencing an unsustainable bubble in the fixed income markets. Fitch Ratings estimates that as of mid-August, $13.4 trillion of bonds were trading at negative interest rates, representing approximately a third of all outstanding global debt. Governments are issuing debt at negative interest rates while running up unsustainable deficits. This deficit data does not include unfunded liabilities for public retirement and healthcare programs, which most experts agree are unsustainable in the long term. Compounding the pressure, spreads have tightened as investors reach further and further for yield. It is difficult to predict when capital market bubbles will end, but typically the longer they continue, the worse the final outcome.

Strong equity returns are being driven primarily by the expansion of PE multiples in an environment of very low global GDP growth and stagnant earnings growth. Brexit, weakness in China’s economy and potential defaults by weaker countries within Europe are quickly shaken off.  Low interest rates provide investors justification for these elevated equity multiples. This, in turn, has caused rising correlation between the equity and fixed income markets.  The massive and continued stimulus by Central Banks around the world since the 2008 crisis has had less and less impact on global growth and has left monetary authorities with very little dry powder to prevent a deeper and more prolonged recession than experienced in the recent crisis. In addition, these dynamics increase the probability of a major market sell-off as central banks continue to artificially prop up markets.

Should investors be holding more cash?

History has proven that most investors are terrible at predicting the direction of the market. To do so successfully requires two correct decisions: when to get out and when to get back in. Investors’ emotions often drive their investment decisions. As a result, they typically buy near market peaks and exit near market bottoms. A much better strategy is to construct a diversified portfolio that can withstand market turbulence. This requires understanding and being comfortable with the tail risk of the portfolio thereby avoiding the need to sell at market bottoms.

Are Investors prepared?

Most institutional investors apply modern portfolio theory to build “efficient portfolios” seeking to maximize forward expected risk-adjusted returns for a multi-asset class portfolio. Calculations to determine optimal asset allocations require assumptions for return, volatility and correlations for each asset class in the model.  Unfortunately, during severe market sell-offs these models have proven to break down.

Correlations between managers and asset classes are dynamic and tend to rise significantly during times of market distress, which combined with a spike in volatility, creates much more tail risk than perceived in investors’ portfolios. Since most public pension funds are heavily under-funded, a prolonged sell-off in the capital markets would leave many plans unable to pay benefits without increased funding at a time when the municipality can least afford to make additional payments.

Can hedge funds help?

Recently, the hedge fund industry has been heavily criticized for poor performance of hedge fund indices. 2016 has been one of the worst performance years ever for hedge fund indices relative to the stock and bond market benchmarks. However, this does not tell the whole story. Hedge Fund indices are biased to do poorly, because they consist of an amalgamation of investment strategies and a broad array of hedge fund managers. With low barriers to entry, the hedge fund industry has swelled to over 15,000 managers, most of whom are not very good. Similar to the mutual fund industry, a majority of funds underperform the indices they are expected to outperform.

It is important to remember that hedge funds are not an asset class but a fund structure consisting of numerous investment strategies. The performance of hedge fund strategies and managers varies greatly as do their correlations to the appropriate capital market benchmarks. Successful investing in hedge funds requires analyzing the strengths and weaknesses of each hedge fund strategy as well as the managers within each strategy.  Some strategies have the potential to have low and possibly negative correlation to the fixed income and equity markets during a market sell-off. In contrast to holding cash that yields close to a zero percent interest rate, many hedge fund strategies have the potential to generate decent returns. Below is a list and brief description of some of these diversifying strategies:

Commodity Trading Advisors (CTAs) – This category includes several different strategies, but is dominated by systematic trend following managers. These managers look to identify and capture price trends across multiple asset classes including currencies, commodities, equities and fixed income. Trend following has been one of the top performing strategies over the past few years and has worked well over long periods of time (even seeing positive, double digit returns in 2008). A pure trend follower is indifferent to fundamental analysis or market valuations. As such, their correlation to the capital markets is, on average, very low. In fact, many have dynamic correlations that are positive in up markets and negative in down markets. Investors should consider building out a diversified portfolio of CTA’s consisting of several different trend following and non-trend following strategies.

Private Lending – Most of these funds are taking advantage of the difficult environment for small and mid-sized companies in securing financing from traditional lenders. There are wide differences in credit quality and yields of funds within the private lending space, but yields are typically much higher than traditional marketable fixed income securities. Many funds hold these relatively short term loans at book and only adjust market value if there is an impairment to credit. As long as the liquidity provisions of the fund match the underlying investments and absent a significant impairment to the credit quality of the loan portfolio, these funds can provide very stable uncorrelated performance.

Reinsurance – This includes a range of strategies with very different return expectations and tail risks. The main common feature of these funds are allocating to a portfolio of insurance policies where the primary drivers of return are insurance premiums earned and claims paid. Property risk (e.g. earthquake, fire, hurricane, and tornado) has proven to have very low correlation to the performance of the capital markets.

Volatility – Short volatility strategies, selling options and collecting premium, have been described as picking up dimes in front of a steamroller. Long volatility strategies, in contrast, can help diversify a portfolio; they tend to have low correlation to the capital markets and often do well during market selloffs as volatility spikes. The value of an option is based on a number of factors including the strike price, time left to expiration and implied volatility of the underlying security. Volatility strategies trade options and futures contracts seeking to take advantage of overvalued and undervalued implied volatility levels in stocks, bonds, commodities, and currencies.

There are many other hedge fund strategies with low correlation to the capital markets such as market neutral equity, relative value fixed income and global macro. While we have not reviewed these in this paper, they are all worthy of consideration and analysis for similar reasons.

Summary

Many investment professionals believe the risk of a major market correction has increased. It is important for all investors to take this possibility into consideration when building out their portfolios. While the hedge fund indices have shown the average hedge fund might not be very good, there are a number of highly skilled managers and strategies that can provide valuable diversification to a portfolio. With fixed income rates so low, many hedge fund strategies have the potential to not only reduce risk, but also to enhance returns.