Equity correlation
A reason for the higher volatility of liquid absolute return funds is that they correlate more with equities than hedge funds. The correlation becomes even higher in times of financial market stress. In 2008, the correlation between the LARI EW Index and the MSCI World Index stood at 0.78, compared to a long-term average of 0.7. “Though most absolute return funds have track records of less than five years, this suggests they do not provide a hedge against declining equity markets,” says Klement.
Though the correlation of offshore hedge funds returns with returns from equities is actually very similar, an analysis of the factors contributing to returns sheds a more nuanced light on the differences between liquid absolute return funds and hedge funds. Klement shows that, while the former have a relatively high correlation with stock market beta, with most of the additional performance explained by the size and value factors, the latter show no real correlation with equity factors and instead correlate very strongly with credit spreads.
“Alternative Ucits funds can therefore not be considered substitutes for hedge funds,” concludes Klement. “To me, the relationship between liquid alternatives and hedge funds is like the links between the oil price and energy stocks. They are not the same, but many investors consider them very similar investments.”
Alberto Montero, the fund selector from Andorra, is not surprised by the stronger correlation of alternative Ucits with equity factors. “Strategies such as long/short equity and equity market-neutral are a relatively important part of the alternative Ucits space, because they are more liquid and therefore more suitable to adapt to the Ucits-format than for example commodity trading strategies,” he explains.
Klement also found that liquid absolute return strategies have, unlike hedge funds, a strong negative correlation with the dollar and even more with US Treasury yields, though he confesses that this is in part due to the fact that hedge funds are mainly US-based with a large exposure to dollar-denominated assets, unlike liquid alternatives which are more popular in Europe.
Thumbs down?
Liquid absolute return funds may be cheaper than hedge funds, fees for long-only stock and bond funds are significantly lower. As adding liquid alternatives to a multi-asset portfolio does not, taking the LARI EW Index as a benchmark, improve risk-adjusted return, Klement concludes they are therefore not a useful complement to such a portfolio.
There is one exception though: low volatility absolute return funds. They have a relatively low correlation with each of the nine factors* identified by Klement, average volatility of only 0.7% combined with average monthly returns of 0.24% (higher than returns for hedge funds) and a maximum drawdown of only 4.7% (compared to 26.6% for LARI EW and 23.6% for HFRX EW).
So these stats appear to show that there is a group of liquid absolute return funds which outperform hedge funds on all accounts. “The problem is, however, that I only identified these low-volatility funds ex-post,” says Klement. So these funds might just happen to be a selection of top-performing absolute return funds, as keeping volatility as low as possible is paramount for such a fund in order to be able to keep its promise of delivering absolute returns.
“It is like it always is in fund selection,” Klement concludes. “There are some very good products, but also a lot of bad ones. And when you then take the average, it’s usually worse than passive funds.”
*market beta; size; value; momentum; Treasury yield; credit spreads; Vix; US dollar; commodities.
To read Joachim Klement’s full article, which was published in the fall 2015 edition of the Institutional Investor Journal, click here
