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Viewpoints

When High Alpha Met Low Beta

A closer look at performance across hedge fund styles.
Summary
  • An in-depth analysis of hedge fund performance demonstrates that, over the past 15 years, lower-beta hedge fund styles have generally achieved higher alpha, aligning with investors' objectives of maximizing returns and diversification.
  • Within the hedge fund landscape, multi-strategy, macro, and trend-following strategies have delivered meaningful alpha while maintaining lower exposure to traditional market betas.
  • The persistence of heightened market volatility may further extend this long-term trend, increasing the appeal for hedge fund strategies that offer the potential for both meaningful defensiveness and alpha.

More specifically, investors have historically tended to seek low beta strategies to diversify traditional asset classes and high alpha approaches in seeking to generate significant excess returns after controlling for traditional market exposures. Although many may assume a trade-off between alpha and diversification potential, that hasn’t been the case: Over the past 15 years, lower-beta hedge fund styles have realized higher alpha.

There are many potential explanations for this counter-intuitive result and each strategy has its own story (see our Featured Solution from March, “Modern Macro,” for a deeper dive). However, one pattern that emerges is that strategies with stronger “crisis alpha” during equity market drawdowns – precisely the scenario investors fear today if recession strikes – have also generated the highest long-term alpha.

Hedge fund strategy performance in 2022 provides the latest striking example. In 2022, while broad hedge fund indices declined 4.1% and $55 billion of capital fled the industry, lower-beta strategies such as multi-strategy, macro, and trend-following delivered positive performance and much-needed diversification.

Widening the aperture, hedge fund industry assets have doubled from $1.9 trillion in 2007 to $3.8 trillion today, despite cumulative net flows of only $42 billion. In other words, hedge fund assets have seemingly grown steadily thanks primarily to long-term performance, but investors need to look under the hood to evaluate which strategies are driving the growth and where capital is flowing. For example, long/short equity has shrunk from 37% to 28% of hedge fund assets since 2007, whereas relative value, macro, and event-driven categories have all grown.

Looking forward, many investors are asking which hedge fund styles are more likely to prosper in an environment of heightened volatility and prolonged higher interest rates to combat inflation (see our Cyclical Outlook from April, “Fractured Markets, Strong Bonds”).

Our framework for evaluating the historical performance of underlying strategies helps explain these trends. As in 2022, periods of high volatility have often coincided with stock market weakness – punishing hedge fund strategies with higher equity beta relative to lower-beta strategies including trend-following and macro.

Winning on both fronts: Positive alpha and increased diversification

The appeal of hedge funds has generally relied upon alpha generation and diversification from traditional asset classes. These are easily quantified with a simple model that regresses hedge fund returns against four major asset classes (equity, interest rates, credit, and commodities). The results show what proportion of a hedge fund’s historical returns is explained by traditional betas versus alpha.

It turns out that over the 15 years ending December 2022, strategies with lower beta to traditional markets – such as multi-strategy, macro, and trend-following – have also generated higher alpha (see Figure 1). This is a compelling “double-whammy” for allocators. Moreover, these results highlight the potential danger of evaluating hedge funds based on total returns alone. For example, a higher-beta strategy may have a greater total return than a lower-beta strategy during a bull market, but the composition of the lower-beta strategy’s return may have significantly more alpha. In a total portfolio context, investors are understandably unwilling to pay hedge fund fees for returns that can be replicated in traditional liquid markets.

 Figure 1 is a chart which shows that lower-beta diversifying strategies have realized higher long-term alpha than long/short equity. More specifically, the chart illustrates what proportion of historical returns for six hedge fund strategies is explained by traditional betas versus alpha over the 15 years ended December 2022. The y-axis shows annual alpha; the x-axis shows the percentage of risk explained by traditional betas. As noted in the text, this analysis is based on a simple model that regresses hedge fund returns for four major assets classes – equity, interest rates, credit, and commodities. Trend-following and macro hedge fund strategies performed best during the period. Trend-following had alpha of about 5.5% with close to 0% of risk explained by traditional betas; macro had returns slightly above 2% with about 15% of risk attributable to traditional betas. Other strategies fared less well: multi-strategy hedge funds generated returns of about 2.5 percent with nearly 60% of risk explained by traditional betas; relative value had returns of about 2% with nearly 80% of risk explained by traditional betas; event-driven strategies delivered annual returns of about 1% with more than 80% of risk due to traditional betas; long-short equity had negative returns of just under 1% with about 90% of the risk explained by traditional betas. PIMCO and Bloomberg are the sources of the data. 

Cyclical outlook favors lower-beta diversifiers

For investors reconsidering their hedge fund allocations, we believe it is critical to assess how the risk of elevated volatility and interest rates could affect various hedge fund strategies. As Figure 2 shows, lower-equity-beta strategies such as trend-following and macro (which had betas of -0.10 and 0.07 since December 1999, respectively ) have done better in periods of high volatility when stocks tend to struggle. In addition, trend-following and macro have outperformed during higher cash-rate regimes – likely, in part, because those strategies have more unencumbered cash available to invest at higher market rates.

Figure 2 presents two bar charts which illustrate that neither high volatility nor high interest rates on cash have been a friend to long/short equity performance over the 15-year period ended December 2022. The left-hand side bar chart shows the annual excess return in high vs. low-volatililty regimes, whereas the chart on the right side depicts the annual excess return in high vs. low cash-rate regimes. Long/short equity’s higher equity beta (a trailing 15-year beta of 0.5) creates a headwind in volatile periods when stocks tend to struggle. In contrast, low-equity-beta strategies such as trend-following and macro (which had trailing 15-year betas of -0.04 and 0.07, respectively) have done better in periods of high volatility than low volatility. In addition, trend-following and macro have outperformed during higher cash-rate regimes – in part because those strategies have more unencumbered cash available to invest at higher market rates. PIMCO and Bloomberg are the sources of the data. 

Follow the trend

The data indicate that the composition of investor hedge fund portfolios is changing – and for good reason. Investors are discerning about where they will pay hedge fund fees, and are gravitating toward styles that are hitting on both alpha and diversification objectives. Elevated volatility and interest rates may prolong this long-term trend, increasing the demand for strategies with superior defensiveness and alpha potential.


1 Performance proxied by the HFRI Fund Weighted Composite Index and flows proxied by total industry data from HFR.

2 Proxies: Trend-following = SG Trend Index; macro = HFRI Macro Index

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Hedge fund and other alternatives strategies involve a high degree of risk and prospective investors are advised that these strategies are suitable only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Performance could be volatile; an investment in a fund may lose money.

Beta is a measure of price sensitivity to market movements. Market beta is 1.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

The HFRI Equity Hedge Index is an unmanaged index that consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100 percent. Aggressive funds may magnify market risk by exceeding 100 percent exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities.The HRFI Macro Index is an unmanaged index that involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities. Macro managers employ a “top-down” global approach, and may invest in any markets using any instruments to participate in expected market movements. These movements may result from forecasted shifts in world economies, political fortunes or global supply and demand for resources, both physical and financial. Exchange-traded and over-the-counter derivatives are often used to magnify these price movements. The HRFI Relative Value Arbitrage Index is an unmanaged index that attempts to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to determine misvaluations. Securities may be mispriced relative to the underlying security, related securities, groups of securities, or the overall market. Many funds use leverage and seek opportunities globally. Arbitrage strategies include dividend arbitrage, pairs trading, options arbitrage and yield curve trading. The Credit Suisse Liquid Alternative Beta - Multi-Strategy Index reflects the combined returns of the individual LAB strategy indices – Long/Short, Event Driven, Global Strategies, Merger Arbitrage and Managed Futures – weighted according to their respective strategy weights in the Credit Suisse Hedge Fund Index. The SG Trend Index calculates the net daily rate of return for a group of 10 trend following CTAs selected from the largest managers open to new investment. The SG Trend Index is equal-weighted and reconstituted annually and has become recognized as the key managed futures trend following performance benchmark.

It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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