This paper looks at the asset class in the context of current market conditions, specifically higher interest rates and the potential for increased volatility, combined with improved access to hedge fund strategies more generally. These factors could create a prime opportunity for liability investors—such as pensions, nuclear decommissioning trusts, and insurance companies—to explore their use. It also discusses the primary risks associated with hedge funds and presents four actionable guidelines for investors aiming to effectively incorporate these strategies into their portfolios. These include defining a clear role for hedge funds, ensuring thorough due diligence, maintaining diversification, and adopting a strategic approach.

Why Consider Hedge Funds Today?

While institutional hedge fund allocations have been reduced in recent years (Figure 1), current market conditions may help to bolster the asset class moving forward.

Higher Interest Rates

Although a “higher-for-longer” interest rate environment can have both positive and negative implications for investors, it tends to be a tailwind for hedge funds. Heightened interest rates and persistent inflation have pushed the short rebate ¹ into meaningfully positive territory for the first time since the GFC (Figure 2), a dynamic that directly benefits hedge fund managers that undertake short selling. While alpha generation remains paramount, the short rebate can function as a stabilizer against volatility for managers with high short exposure, such as long/short equity managers. Higher interest rates also mean increased returns on cash. This is an advantage for managers that have significant amounts of free capital, whether they are operating global macro strategies, relative value strategies, or other approaches involving derivatives.

Increased Volatility Potential

Although volatility has remained relatively low through the first half of 2024, the rapid emergence of generative artificial intelligence is likely to continue to impact volatility in various market sectors over the near term. Moreover, geopolitical uncertainty—including the war between Russia and Ukraine, ongoing conflicts in the Middle East, and US-China tensions—also has the potential to create elevated market turbulence.

What’s notable here is that hedge funds have traditionally thrived amid heightened volatility. This is because greater volatility results in greater dispersion of returns among individual securities and asset classes more broadly, often with projected highs soaring higher than expected and projected lows drawing lower.

As the market identifies winners and losers and companies compete for capital, more alpha opportunities become available to diligent hedge fund managers. Nimble asset managers can also look to capitalize as disparities between a company’s business fundamentals and security price become more defined, creating additional trading opportunities. It is also important to note that hedge fund allocations have the potential to offer portfolios protection from unexpected market headwinds, particularly those designed to be less correlated to traditional sources of return.

Improved Access

Investors allocating to hedge funds today have access to opportunities that they could only dream of a decade ago, partly due to increased openness and innovation within the industry. What’s more, regulatory changes have helped to improve hedge fund transparency. Lastly, technological advancements have helped make it easier to retrieve and analyze information about hedge funds in the pursuit of strategies that are best suited to specific portfolio needs.

Implementation: Four Actionable Guidelines

Even amid more favorable market conditions for hedge funds, investing success depends on effective portfolio implementation. Four important action steps will help institutional investors determine which strategies can complement their broader investment goals.

1. Clearly Define the Role of Hedge Funds in the Portfolio—and Adapt as Needed

Given the wide array of hedge fund strategies available, it is critical to first set clear goals and expectations around the role they will play in a portfolio and seek out managers that match this profile (see Case Study: Enhancing Pension Health with Hedge Funds). Traditionally, hedge funds have been positioned to generate returns between those of bonds and equities, with the expectation of sub-equity volatility.

However, allocations should be carefully customized to an investor’s specific needs and risk tolerance (Figure 3). Where some investors may be willing to take on more risk for more return potential, others many want a highly diversifying hedge fund portfolio that seeks to generate returns with low-to-no equity beta. By setting clear goals, investors can access managers that better align with their risk and return objectives. Regularly reviewing and adjusting hedge fund allocations can help ensure they continue to meet these goals.

2. Rigorously Evaluate Managers to Uncover Top-tier Partners

The hedge fund landscape presents substantial divergence in performance outcomes across managers. Working with top-tier managers is essential, as seemingly negligible differences among managers’ expertise and investment approaches can lead to materially different returns (Figure 4).

Historically, the hedge fund industry has been categorized by notable manager turnover due to the risks associated with the use of intricate financial products and balance sheet leverage. Navigating this universe and underwriting new funds demands a due diligence process that requires considerable time and resources. However, this effort is vital and will help investors uncover managers with high-quality investment processes, fund administration, and risk management.

To ensure thorough due diligence, investors should establish clear criteria for manager selection, including track record, investment strategy, risk management practices, and alignment of interests. A comprehensive quantitative analysis of historical performance, including metrics such as Sharpe ratio, alpha generation, and drawdown analysis, is crucial. Tools such as Monte Carlo simulations can be invaluable for stress-testing performance under various market conditions. Additionally, in-depth qualitative assessments through interviews and on-site visits can provide insights into the manager’s investment philosophy, team structure, and operational infrastructure. Engaging third-party service providers for background checks, legal reviews, and operational due diligence helps uncover hidden risks. Comparing potential managers against a peer group using industry benchmarks and databases offers a well-rounded view of their relative strengths and weaknesses.

Many leading hedge funds today are large and complex organizations whose proper evaluation requires significant industry experience. Investors must undertake comprehensive risk assessment to avoid blowups. With the rise of new trading platforms and the increasing commoditization of fundamental research, it becomes even more valuable for allocators to possess deep expertise and substantial global resources. This is necessary not only to proficiently underwrite funds, but to discern the sustainability of a manager’s competitive edge and identify top emerging talent. Understanding the nuances of the manager’s strategy, including their edge in the market, sources of alpha, and competitive advantages, is crucial. Assessing the robustness of the manager’s operational infrastructure, including compliance, reporting, and fund administration, is also essential. Collaborating with industry experts can provide valuable insights and validate findings.

Among the more than 8,000 hedge funds operating worldwide, Cambridge Associates believes that fewer than 2% merit investment consideration. Accessing these “high conviction” funds can be challenging but can improve as investors build relationships with fund managers. Most managers value their client relationships and are often willing to negotiate capacity. This underscores the importance of a proactive, informed approach that emphasizes strategic partnerships. We believe by actively networking within the industry, investors can build relationships with top managers and unlock exclusive opportunities. Being well prepared when negotiating terms and capacity can secure more favorable investment conditions. Additionally, demonstrating a long-term commitment fosters collaboration that can lead to superior investment prospects.

3. Use Hedge Funds to Optimize Diversification

In today’s investment environment, a thoughtfully diversified portfolio requires iterating beyond the traditional 60/40 split between equities and bonds. Investors should consider increasing allocations to alternative investments to provide valuable and differentiated sources of return, downside protection, and liquidity during times of market stress (see Case Study: Navigating Yield Uncertainty, Insurance Firm Turns to Hedge Funds).

While private equity and venture capital deserve consideration, they are highly illiquid, and cannot be used for regular rebalancing or ongoing cash needs. Hedge funds, however, offer a middle ground. They provide more liquidity than private asset classes and, given the wide array of available strategies, can offer the potential for robust returns in various market environments.

Executed effectively, hedge funds have the ability to play an all-weather role in a portfolio. For instance, in 2022, as equities and bonds suffered material losses, many hedge fund managers generated positive returns for the calendar year. Pensions with hedge fund allocations have tended to show more resiliency amid such market drawdowns (Figure 5).

Investors looking for greater consistency in down markets can consider absolute return-oriented funds, which aim to provide positive absolute returns regardless of backdrop. Those expecting inflated default rates following higher-for-longer interest rate conditions can consider credit-oriented funds that excel in identifying and profiting on struggling businesses and/or dislocated securities. Over the past 20-year period, hedge funds have provided moderate returns with lower volatility than equities, helping to balance risk and deliver diversification benefits in an ever-changing investment landscape (Figure 6).

4. Use a Strategic Mindset to Overcome Valid—But Not Insurmountable—Hedge Fund Challenges

Investors are right to be concerned about hedge fund fees, transparency, and liquidity, but a well-informed, strategic approach can help unlock their potential.

While the hedge fund industry is known for its “2 and 20” fees—2% management fee and 20% performance fee—investor costs and terms are often negotiable, particularly with scale. It is critical to ensure fees are reasonable relative to expected alpha and to only invest with managers offering compelling return potential net of all fees.

Similarly, investors should only invest with hedge funds that offer appropriate transparency. Transparency is central to assessing the strategies employed by the fund. Investors should demand clear, comprehensive reporting on holdings, risk metrics, and performance attribution so that they can make informed allocation decisions. Greater transparency not only aids in understanding a fund’s approach and alignment but fosters trust between investors and fund managers.

In terms of illiquidity, adopting strategies that reduce an investor’s readily available capital may be justified in some cases, as long as the overall portfolio maintains adequate liquidity levels. Investors should complement less-liquid strategies with those that provide quarterly, monthly, or more frequent liquidity options to ensure a capital reserve during stressful periods. For those with greater liquidity needs, building well-diversified hedge fund allocations offering full quarterly liquidity is advisable.

Conclusion

Economic conditions and financial markets are unpredictable. Despite 2023’s equity bull run and its continuation in early 2024, investor circumstances can always change. For pensions, insurance firms, and other liability-focused investors, being positioned to withstand volatility is a critical component of successful portfolio management. Despite the skeptics, hedge funds can offer an attractive option for enhancing portfolio diversification and returns, especially in an environment of interest rate uncertainty and elevated volatility.

However, understanding risk is the essence of informed decision making. Action items for investors include: clearly defining the role of hedge funds within the portfolio; seeking out the highest quality managers; maintaining diversification; and adopting a strategic mindset to navigate inherent challenges. By carefully pursuing these actions, liability investors can successfully leverage hedge funds to help achieve their investment objectives, ensuring a balanced approach to risk and return in an ever-changing investment landscape.

Melanie Mandonas, Managing Director, Pension Practice

Index Disclosures

Bloomberg Aggregate Bond Index
The Bloomberg Aggregate Bond Index is a broad-based fixed income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

HFRI Fund of Funds Composite Index
Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers. PLEASE NOTE: The HFRI Fund of Funds Index is not included in the HFRI Fund Weighted Composite Index.

MSCI All Country World Index
The MSCI ACWI captures large- and mid-cap representation across 23 developed markets and 24 emerging markets countries. With 2,760 constituents, the index covers approximately 85% of the global investable equity opportunity set.

S&P 500 Index
The S&P 500 is a market capitalization–weighted stock market index that tracks the stock performance of about 500 of some of the largest US public companies.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.

The post A Liability Investors’ Guide to Reassessing Hedge Funds appeared first on Cambridge Associates.

New Dynamics, Old Strategies?

Plan sponsors today are operating in the aftermath of one of the fastest rate hikes in history and a prolonged yield curve inversion. Discount rate increases, along with strong equity performance since the March 2020 COVID-19 bottom, have powered significant improvements in funded status (Figure 1). These factors have proven especially beneficial to plan sponsors with underfunded and underhedged plans, helping them catch up with those that have spent the past decade contributing to their plans and increasing their liability-hedging targets.

Most DB plans today also have much improved risk profiles. Funding relief regulations such as MAP21 ² and ARPA ³ have stabilized the interest rates used for determining plan contributions and lengthened the time periods available to plans for addressing funding shortfalls (Figure 2). These measures have helped to make funding more predictable over the long term by using a moving average yield to determine funding requirements. As a result, pension plans have much lower contribution risk as compared to two decades ago. Even with the steep rise in discount rates devaluing some of the cost savings from these regulations, it is still important for plan sponsors to recognize that these changed dynamics are likely here to stay. What’s more, they may need to reconsider how they manage their plan to remain on track for long-term success.

Shifting Gears

Plan sponsors have four key levers to manage their pensions—asset returns, liability hedges, contribution policy, and benefit management (Figure 3). While these levers do not change over time, how they are operated should, as plan sponsors look to remain on track with plan goals and objectives. Whether a plan is recently closed, frozen, or open, the observations we share below are broadly applicable to ensuring its optimized management.

Growth Assets: Meeting New Goals Amid New Risks

Although many plans today are well funded and well hedged, growth assets remain a critical component of overall plan health, helping to offset administrative expenses, unfavorable demographic trends, actuarial assumption changes, and other unhedgeable aspects of liabilities. As later discussed in the benefits management section of this paper, a properly executed growth strategy can also increase a plan’s overall value to an enterprise by reducing the cost of retirement and other employee benefits and by funding other organizational priorities.

Even though many plans have been focused recently on investing in a higher interest rate environment, these allocations alone may not provide adequate diversification in the event of market volatility. This volatility could be driven by multiple variables, including additional interest rate changes, an economic recession, increased pressure in the banking sector, heightened geopolitical tensions, or any black swan event.

Private credit, high-yield fixed income, hedge funds, and real assets are all strategies with the potential to help enhance diversification, provide downside protection, and achieve superior returns. Of these strategies, private credit can be particularly advantageous. Higher yields, coupled with a floating rate structure, may prove beneficial in a rising rate environment, with some strategies providing risk mitigation due to senior standing in companies’ capital structure. As with any private asset class, however, conducting robust due diligence will help achieve superior returns and avoid strategies that appear favorable on the outside but may contain hidden risks on the inside, such as subpar lending standards, poor execution, and unfavorable deal flow.

As plan sponsors evaluate their growth-oriented options, they should validate their true liquidity needs. Doing so may enable them to unlock their portfolio’s full growth potential by using excess liquidity to take advantage of opportunities in higher return, generating private equity investments (Figure 4). A liquidity coverage ratio of 2x to 3x can help ensure a portfolio is positioned to tolerate periods of market stress.

The liquidity risk of private investments in a pension portfolio varies depending on its net cash flow. As net distributions increase, the optimal allocation to private investments decreases (Figure 5). Partnering with experts in the private investment space is crucial to understanding the implications of these cash flow dynamics. The days of investors shooting in the dark to build out private investment allocations are over, as data and technology improvements make it easier to analyze liquidity requirements in an asset/liability context.

Liability Hedging: Less May Be More

Many plan sponsors have been highly focused on increasing long-duration liability-hedging assets in recent years. However, it may be time to reconsider how to manage liability risk going forward, including the appropriate amount of capital committed to these strategies and the optimal mix of credit duration. As always, a plan’s liability-hedging strategy is informed by its funded status. It follows that improvements in funded status should inspire a revised approach to liability hedging. As plan sponsors consider their options in today’s investment landscape, they now have a better set of tools at their disposal.

For example, because the accounting discount rate for single-employer pension liabilities is based on the Aa yield curve, a portfolio of duration-matched bonds can provide a good hedge against interest rate volatility. The earlier use of a completion manager may also help to keep higher hedging ratios, while also freeing up capital to implement more effective credit risk management and achieve additional exposure to growth assets.

It’s important for plan sponsors to recognize that the old paradigm of devoting the vast majority of plan assets to liability hedging should evolve into a more balanced approach. In fact, with liability durations decreasing relative to many fixed income assets today, more hedging can be achieved with fewer dollars. Less commonly used investment strategies, such as intermediate credit, also can play a role here. They can offer multiple potential benefits, including increased yields, liability carry offset, and better credit curve exposure, which in turn can result in lower volatility and higher returns.

Plan sponsors should also evaluate the overall fit and relative importance of liability hedging for their plans. There is now diminishing marginal utility in hedging the “last-mile risk” in pension portfolios with more capital. In some cases, an excessive hedging effort may result in a lower returning liability-driven investment (LDI) program, which decreases the efficiency of not only the liability-hedging assets, but the entire portfolio. Instead, plans may pick up incremental yield by adding non-traditional instruments for hedging, such as private investment-grade credit, commercial mortgage loans, and securitized assets. This may help the liability-hedging portfolio keep pace with the higher interest cost on liabilities, while still reducing interest rate risk through completion or other Treasury strategies. Figure 6 depicts how allocating only 30% of the liability-hedging portfolio to more diverse hedging assets can result in 50 basis points of extra annual yield.

For plan sponsors whose main objective is controlling or minimizing contribution requirements, hedging liabilities may introduce additional risk. In this scenario, plans should consider blending total return investment approaches with specialized liability-hedging programs to achieve the optimal outcome. The recent rise in discount rates has also presented a new option—adjusting contribution requirements to be based on mark-to-market liabilities. This option allows a liability-hedging program to not only reduce accounting funded status risk, but also contribution risk.

Contributions: A New Paradigm

Even if plans should experience negative asset returns in the near term, they can afford to be less concerned about contribution volatility due to the favorable impact of regulatory changes on funding target ⁴ calculations. The significant funding relief options passed in the last decade have resulted in the adoption of higher interest rates for minimum required contribution calculations. For example, plans are allowed to discount liabilities using 25-year moving average rates, which are then bound by interest rate corridors. When higher discount rates are used, liabilities are lower, which leads to higher funded status and lower contribution requirements.

In addition, due to new shortfall smoothing rules, a decline in funded status will no longer result in exceedingly high mandatory contributions. This changed regulatory backdrop, coupled with revamped asset and liability management options, effectively lightens the load for plan sponsors, potentially freeing up corporate assets for other purposes, including critical enterprise goals.

Contribution risk should generally be considered separately from funded status risk, since the duration for liabilities used to determine contribution requirements is essentially zero. While the use of long-duration fixed income strategies is beneficial to hedge long-duration accounting liabilities, it has a countereffect for liabilities with zero duration. While this wasn’t much of an issue when interest rates were low, the disparity is presenting a bigger opportunity in today’s higher interest rate environment. Well-hedged plans can consider aligning accounting and funding target methodologies through the Full Yield Curve approach, which may not only reduce expected contribution requirements, but eliminate much of the contribution volatility risk.

Underhedged plans should be more cognizant of the difference and focus on controlling the risk that is most important for them—balance sheet or contribution volatility. Even under the stabilized interest rate approach, certain aspects of pension management, such as Pension Benefit Guaranty Corporation (PBGC) premiums, are sensitive to interest rate changes. The most risk-efficient plan portfolios often blend traditional investments with LDI strategies in accordance with plan sponsor objectives and circumstances.

Benefits Management: Reassessment Required

Multiple benefits management approaches are always available to plan sponsors. These include plan termination, hibernation, partial risk transfer, future benefit modification, maintaining an open plan, or even re-opening one. Each of these approaches carries direct and indirect costs and risks. A close consideration of the plan sponsor’s specific needs and goals will help determine the right way forward.

Many plan sponsors can evolve their DB plans from feeling like a burden to feeling like an asset, one that supports corporate goals and financial health. Thanks to effective benefit management—combined with more supportive plan regulations and tools for generating asset growth and managing liabilities and contributions—plan sponsors are able to extend the life of their DB plans. Well- and over-funded pensions can become a point of differentiation for these enterprises and a valuable tool in attracting and retaining talent for the organization. Surplus plan assets also can be used in other ways that are long-term value additive to an organization, including mergers & acquisitions activity and retiree medical benefits. As plan sponsors consider a DB plan restart, expansion, or extension, they are likely to find that DB plans come at a marginal cost compared to defined-contribution plans. In fact, the National Institute on Retirement Security estimated that a DB plan costs 27% less than an “ideal” defined-contribution plan—one with fees below the industry average delivering strong performance. ⁵

Those sponsors closer to the termination side of the spectrum should consider how they can approach de-risking economically. For instance, many lean toward offering a lump sum payment option to plan participants; in this scenario, participants who receive a payment are no longer due a benefit from the plan. While this seems routine enough, it is important that payments be apportioned strategically so they result in less assets transferred than the liability. Generally, cost savings occur during declining interest rate environments that generate a lower lump sum payment relative to the market-to-market liability. However, this strategy can backfire in a rising rate environment and result in many plan sponsors having to contribute capital in order to terminate as lump sums become more expensive than buying annuities. Similar issues can occur for plans opting for pension risk transfers (PRTs) via lump sum windows.

Partial PRTs are commonly used with the idea of reducing plan size for purposes of PBGC premium savings. However, for most underfunded plans, this kind of transaction may actually negatively impact funded status and increase plan costs and PBGC premiums over the long term—even if the amount of assets transferred is less than the liability (or a gain to the plan). All sponsors should fully understand the implications of PRTs in terms of funded status, risk reduction, and future costs for their plan. For many plans, managing risk through asset allocation decisions is more effective.

Achieving a surplus position is never easy or risk free—and may be prohibited by many glidepath designs, especially those that aim to lock in funded status at a point just above 100% funded. For this reason, plan sponsors should reconsider the end stage of their glidepath, given the utility of a surplus and the potentially higher funded status needed to terminate without cost if a previous PRT has already been performed. Plan sponsors wishing to use surplus assets may find that increasing allocation to growth strategies could be advantageous as the plan moves higher in funded status, with the notion that the further away the plan is from becoming underfunded, the more risk a plan can take in pursuit of higher surplus.

Adaptability Is Key

Although pension plans today are experiencing much improved funded status relative to years past, the extent to which they take advantage of the opportunities made available by favorable improvements in funding and regulations will be a key determinant of their future health.

In all market conditions, the four levers that plan sponsors control as they seek to accomplish their objectives remain the same. However, an informed, adaptive approach to the operation of each will help ensure continued plan success over the near and long term. Plan sponsors are strategizing for growth and managing risk in in a significantly different investment environment. To accomplish their goals, it is imperative that these changes be taken into consideration. By taking a fresh look at their investment strategies and plan management, organizations have an opportunity to adapt, evolve, and reap significant benefits.

Serge Agres, Managing Director, Pension Practice

Cathy Xu, Investment Director, Pension Practice

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post A Changed Investment Landscape Is Providing Greater Opportunity for US Corporate Pensions appeared first on Cambridge Associates.

Bitcoin ETFs are unlikely to impact sophisticated investors in the near term because few are interested in exposure and those that are interested in the space may already have exposure to bitcoin-only or broader crypto asset closed-end funds, which have existed for years. Still, retail flows to these bitcoin ETFs will likely be substantial. These flows will improve the market’s depth, increase options and futures activity, and attract more hedge funds to the space. As a result, sophisticated investors may acquire modest exposures to the space over time via existing hedge fund exposures.

The approval of bitcoin ETFs does not signal a shift in the SEC’s skeptical attitude toward crypto assets, and the broader regulatory environment in the United States remains cloudy. The United States lagged some countries in spot bitcoin ETF trading, but it is ahead of other jurisdictions. On broader crypto regulations, the United States is behind the EU, and some countries in the Middle East and Asia. We do not expect any changes in the US regulatory situation until after the 2024 election, if at all.

Investors targeting bitcoin exposure will have to decide whether to hold the asset directly or via an ETF, much like the dilemma gold investors face. Those investors that prefer to hold gold bullion will likely also prefer to hold bitcoin directly. But, as with gold, investors will need to decide if a speculative bitcoin investment makes sense in their portfolios.

Joe Marenda
Head of Hedge Fund Research and Digital Assets Investing

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post SEC Approves Spot Bitcoin ETFs appeared first on Cambridge Associates.

Equity Long/Short Performance Should Be Above Average in 2024

Joe Marenda, Head of Hedge Fund Research and Digital Assets Investing

We expect equity long/short (ELS) hedge funds should perform above the industry’s long-term average in 2024, due to the considerable rise in short rebates and economic conditions within major geographic regions. We believe this will support US ELS generalist strategies and sector specialists, as well as regionally focused ELS funds in Europe and Asia.

Higher short-term interest rates have increased the short rebate to levels unseen since the GFC. In fact, a fund’s short book now generates yields greater than benchmark equity dividend yields for the first time since 2008. A higher short rebate improves potential future performance, as it lowers the cost of carrying short positions and increases the opportunity set for single-name shorts.

The weak economic backdrop we expect in 2024 should lead to a greater focus among investors on earnings and free cash flow. This positions ELS funds well, as companies that have been cheap on a fundamental basis may perform better and companies that are expensive may be strong candidates for shorting.

In Europe, dispersion is above median among listed companies, which suggests that active stock pickers have an above-average field of candidates for longs and shorts. Economically transformative dynamics—reshoring of supply chains and a wall of low interest rate loan maturities, the latter of which will peak in Europe in 2026—will lead to clear winners and losers among European companies.

In Asia, where long-biased strategies did particularly well over the last decade, we expect less directionally biased ELS funds should outperform in 2024. Market leadership and underperformance are likely to shift more rapidly among companies and countries in Asia in 2024 than over the past decade, which will give more nimble portfolios greater alpha opportunities.

In the United States, the same dynamics facing Asian managers and the broader European economy will set up US ELS and sector specialist funds for a wide dispersion of outcomes. Historically popular long-biased sector strategies are likely to face pressure from peers with lower net exposures and greater skill at selecting alpha generating shorts. In 2024, long out-of-favor US value ELS funds should perform particularly well.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post 2024 Outlook: Hedge Funds appeared first on Cambridge Associates.

Read the full article. 

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.

The post Macro Hedge Funds Lead Gains in Asia appeared first on Cambridge Associates.

Aaron Costello, Regional Head for Asia, and Vivian Gan, Associate Investment Director, Capital Markets Research

The path of global central bank tightening remains a top-of-mind question for investors after the recent stress in the US and European banking sectors. While financial contagion seems contained for now and has yet to spread to Asia, the current environment of higher rates and the risk of slowing global growth pose challenges for Asian markets. Furthermore, China’s reopening has boosted the outlook for the region as a whole, but heightened US-China geopolitical tensions remain a risk. In this edition of Asia Insights, we highlight areas we continue to find opportunities in, despite the current environment of higher rates and market uncertainty.

• Public Equities: After receiving muted interest from international investors over the past decade, Japanese equities deserve more investor attention, given higher relative earnings growth momentum, low starting valuations, and strong corporate balance sheets that are attractive qualities in the current environment. Over the longer horizon, regulatory changes and increased activist engagement will help improve the return profile of Japanese equities.
• Private Investments: Global fundraising and deal activity slowed in 2022, and Asia private equity and venture markets were not spared. Capital availability and deal activity in Asia may remain tight in the near term, as international investors seek to reduce geopolitical and emerging markets risk. However, this presents an opportunity for high-quality managers that face lesser capital constraints.
• Real Assets: Rising interest rates across major Asian economies have eroded the attractiveness of Asian real estate and led to a meaningful decline in recent investment activity. Within the current environment, however, Japan opportunistic real estate strategies can still offer investors a higher return profile, given lower borrowing costs arising from the divergence in the Bank of Japan’s monetary policy from other Asian central banks.
• Hedge Funds: Asia equity long/short strategies have successfully generated alpha in recent years, although they have underperformed their global counterparts given the relative weakness in Asian equity markets. However, we view that the tide is turning for Asia long/short strategies, as the current environment of higher rates and volatility, together with China’s reopening, present a positive backdrop for managers that can generate alpha on both the long and short side of their portfolios.

Public Equities: The Stars Are Aligning for Japanese Equities

Wilson Chen, Managing Director, Public Equities

Investor interest in Japan has been muted, as flat valuation multiples and the yen’s weakness saw Japanese equities underperform their developed markets (DM) counterparts. Over a trailing ten-year period, Japanese equities returned 9.1% ⁶ and 5.4% in local currency and US dollar terms, respectively, versus 10.5% and 9.8% for DM ex Japan equities. Looking forward, we view that there are short- and long-term tailwinds for Japan that warrant closer investor attention.

In the near horizon, Japan still stands to benefit from the reopening of its domestic economy and China’s alike in the form of renewed tourism spending. Corporate earnings growth in Japan – which has been stronger than its DM peers over the past decade – is likely to sustain its positive momentum because of the divergence in monetary and fiscal policy in Japan versus other developed economies. Furthermore, Japanese companies tend to have strong cash balances and balances sheets, allowing them to remain more resilient amid higher market volatility and slowing global growth.

Current valuations for both Japanese equities and the currency remain undemanding. While Japan trades close to fair value in absolute terms, valuations relative to DM ex Japan are low at the 25th percentile of historical observations. Real exchange rate valuations for the yen versus the US dollar are also near all-time lows, reducing downside risks from further yen weakness, especially if the Federal Reserve pauses its rate hike cycle later in the year.

There are positive signs that inflation in Japan is ticking up. While some of this was due to higher import costs, we are seeing evidence today of wage growth and companies increasing prices after years of holding back. A transition from a deflationary to an inflationary environment would induce a paradigm shift, as attitudes toward domestic consumption and investment change. Over the longer term, policy changes emphasising increased governance and shareholder returns – including the unwinding of cross shareholding and the increasing of share buybacks – coupled with a rise in activist engagement, will further enhance the return profile and attractiveness of Japanese equities.

Private Investments: Capital Availability and Deal Activity Likely to Remain Muted for Now

Vish Ramaswami, Managing Director, Private Equity

2022 saw a dramatic fall in dollars raised and deployed by Asia private equity and venture capital (PE/VC) funds. Asian venture markets were hit by the global crash in technology and biotechnology valuations. Returns of mature funds were impacted, dampening the outlook for new fundraising. Meanwhile, companies faced difficulties raising new equity rounds, given flat valuations, and new company formation slowed. Growth and buyout deals have also seen weaker operating metrics over the past two to three years, which affected portfolio marks and dragged down returns. The denominator effect ⁷ has forced limited partners (LPs) to cull managers. Availability of capital fell, while cost went up.

This downward trend mirrors that of other regions. However, in an environment of uncertainty, illiquid commitments suffered additionally in less-proven markets fraught with political or currency risks, such as Asia-Pacific. The impact is particularly pronounced in China, which has absorbed and invested the vast majority of VC raised in Asia but is in a unique geopolitical standoff with the United States. The latter is where most LPs are based and is integral to VC activity, from idea generation to public markets for exit. Beyond VC, we also see a general pullback from China by managers with regional or global mandates.

Meanwhile, ex-China country-focused and regional funds have also seen fundraising slow, reflecting the cautious mood toward Asia-Pacific more broadly. This general muted sentiment is likely to persist over 2023, and coupled with tighter capital availability, means that deals are taking longer to close. PE deals are re-pricing, favouring overcautious buyers, and VC may see flat or even down rounds as the prospect of public market exits becomes more distant.

Amid all this, high-quality managers have raised healthy sums and are optimistic that the situation presents a good investing environment for those with capital. LPs with dry powder face an opportune moment where hitherto access-constrained managers are now open to new capital. The additional silver lining is that the collapse of Silicon Valley Bank (SVB) has had little impact on Asia-Pacific, given few portfolio companies in the region banked with SVB and venture debt, in any case, is a very small portion of overall venture activity.

Real Assets: Japan Remains a Bright Spot Within Asian Real Estate

Johnny Adji, Senior Investment Director, Real Assets and Private Credit

Asia commercial real estate activity saw a marked decline in 2022, and the outlook for the market remains muted in the near term. Rising interest rates across major Asian economies have increased the cost of new acquisitions financing. At the same time, elevated inflationary pressures and cooling global growth have placed a drag on the income return to Asian real estate, particularly for non-residential, commercial sectors.

Across developed Asia markets – including Australia, Hong Kong, Singapore, and South Korea – traditional real estate investments appear even less attractive considering the negative carry yields arising from higher borrowing costs in tandem with lower capitalisation rates. With transaction volume and valuations remaining under pressure, we expect capitalisation rates for these segments to edge upward – potentially expanding by 75 basis points (bps) to 100 bps in the next six to 12 months – following a similar recent trend in the United States and Europe. Alternative real estate strategies (e.g., schools and data centres) in these markets are slightly more attractive as they offer higher yields, although elevated interest rates are still weighing on the overall return profiles. While the same picture looks to hold for Asia emerging markets such as China and India, the outlook there is somewhat more positive, as a result of the countries’ higher economic growth and potential real estate rental growth.

Against this backdrop, we view that Japan continues to be a bright spot for real estate strategies. In contrast to its Asian peers, borrowing costs in Japan remain relatively low, driven by the country’s lower levels of inflation and the Bank of Japan’s commitment to its ultra-loose monetary policy to stimulate economic growth. Capitalisation rates in Japan also remain stable, ranging from 3.8% for traditional real estate to up to 7.5% for alternative sectors. Furthermore, low interest rates in Japan imply that USD-based investors can pick up carry yield from hedging back to the US dollar (while also removing currency risks). As a result, managers investing in Japan real estate are more likely able to achieve their target returns without having to either underwrite capitalisation rate compressions or aggressive rental growth rates.

Hedge Funds: The Tide Is Turning for Asia Equity Long/Short

Benjamin Low, Senior Investment Director, Hedge Funds

Investor sentiments toward Asia equity long/short (L/S) strategies have been dampened by the ongoing volatility in China, as well as the broader weakness of Asian equities relative to their global peers. Indeed, since mid-2021, the performance of Asia L/S funds has trailed that of their global counterparts, although they still managed to add value over the broad Asia market.

Going forward, we view that the outlook for Asia L/S strategies is turning more positive, driven by increased alpha opportunities arising from current market conditions. Higher funding costs and market volatility have led to a wider dispersion between fundamentally strong and weak companies, allowing for alpha creation on both long and short portfolio allocations. Short rebate has turned positive with the rise in global interest rates, providing a boost to returns for funds that have a meaningful short allocation. The continued reopening of China’s economy will also lead to a re-rating in China and other Asian markets as investment capital returns to the region. Managers with proprietary fundamental research capabilities will be better poised to benefit from China’s rebound, particularly in emerging themes such as advanced manufacturing and clean energy where there are no clear winners yet.

Fund managers that can generate consistent short alpha in the current environment will gain traction from investors. However, managing fund capacity will be critical, as a rapid growth in assets under management could necessitate investments into less inefficient segments of the market and erode alpha. Furthermore, while current financial conditions bode well for equity L/S managers, elevated inflation and rates are still headwinds for equities in general. Most Asia L/S fund managers are less versed in navigating through a high inflation environment, increasing the odds of more fund closures in the horizon. However, as manager crowding lessens, the competitive landscape and overall performance of Asia L/S is likely to improve as a result over time.

Drew Boyer and Derek Yam also contributed to this publication.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.

The post Asia Insights: Navigating Higher Rates and Volatility appeared first on Cambridge Associates.

Continued Inflation Uncertainties Underpin Our Optimism in Macro Hedge Funds in 2023

Meisan Lim, Managing Director, Hedge Fund Research

More than at any time in recent history, both equities and bonds have been very sensitive to macro events, particularly to inflation prints. During periods of large positive US inflation surprises, macro hedge funds have tended to do better than a typical 60/40 portfolio. Conversely, when inflation has surprised materially to the downside, these managers have underperformed 60/40, though still managed to generate positive returns.

After the high inflation experienced in 2022, is the case for macro hedge funds still intact? We believe so. First, we suspect risks are skewed to either matching or exceeding current inflation expectations in 2023, which for the United States and euro area are 4% and 6%, respectively, according to Bloomberg. As a group, macro funds have a wide range of resources to identify mispricing and can choose from a variety of instruments to maximize their payout.

Other tailwinds support our thesis that macro strategy will do well in an environment susceptible to inflation surprises. Rather than focusing on promoting maximum employment as it did in the low-inflation era, the Federal Reserve is now forced to favor combating inflation by raising the Fed funds rate. The market is pricing in that the Fed will stop tightening in May 2023 with a terminal rate of 4.9%, and, as written elsewhere, we believe a pause in tightening after May is more likely than a pivot to easing policy rates. This will impact discount rates, making stocks and bonds vulnerable, and provide good short-selling opportunities for macro managers.

Furthermore, when quantitative easing flushed the markets with liquidity and drove investors to reach for yields higher up the risk curve, concentrated beta-driven portfolios were more attractive than a diversified portfolio with many alpha sources. Now that monetary tightening is in effect and interest rates have risen, macro managers are in an opportune position to benefit from greater alpha opportunities and diversification of assets and geographies.

With loose monetary conditions and unusually low inflation in the rear-view mirror, macro funds that are uncorrelated to traditional portfolios of stocks and bonds will prove useful diversifiers.

Positive Short Rebates Will Help Long/Short Equity Performance Improve in 2023

Eric Costa, Global Head of Hedge Funds, and Stephen Mancini, Senior Investment Director, Hedge Fund Research

We expect the short rebate available to long/short managers will remain positive next year, given our view that the Federal Reserve will not pivot to cutting interest rates. This rebate, which short sellers receive when they borrow stock, has ranged between -50 basis points (bps) and 0 bps for much of the last 15 years. The recent shift of the short rebate into positive territory removes a clear hurdle for long/short equity funds, and we expect it will help performances in this space improve next year.

In addition to the short rebate, the return components of long/short equity strategies include the long alpha, short alpha, beta, and fees. Skilled long/short equity managers typically generate long alpha on a consistent basis over time. Generating short alpha is challenging and often lumpy, while creating absolute dollar profits from the short portfolio is even more difficult. In fact, absolute short profits have been essentially non-existent since the Global Financial Crisis.

A large, short rebate acts as a return floor, reduces performance volatility, and helps to cover management fees. Simply put, the short rebate is the current Fed funds rate minus a spread (typically 25­ bps to 50 bps) multiplied by the total gross short exposure of the manager. Long/short equity managers with robust short portfolios of individual equities will benefit more than managers with small, short portfolios. This being said, the short rebate should not drive investment decisions. The ability to generate long and short alpha remains most critical.

While directional, growth-oriented long/short equity managers benefited the most from the zero interest rate policy and quantitative easing regimes, the current economic environment should result in more obvious winners and losers as companies must now compete for capital. High-quality businesses should trade at a premium, while low-quality, cash-burning businesses should trade at a discount. Dispersion within equity markets is increasing as is volatility. This is an excellent backdrop for alpha creation on longs and shorts as long/short strategies tend to do well relative to equities during periods of heightened volatility.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.

The post 2023 Outlook: Hedge Funds appeared first on Cambridge Associates.

This paper discusses how multiemployer pension plans can optimize their investment strategy using existing plan assets as well as SFA funds. Plans that allocate across traditional and alternative asset classes—including private investments—can increase their likelihood of maintaining solvency to 2051 and beyond. We begin with a general overview of the SFA program, with a focus on the investment implications for multiemployer pension plans.

Background: The SFA Program

The SFA program was initiated following ARPA’s passage into law in March 2021. It organized pension plans into six priority groups, with the most troubled plans receiving funds first. Plans deemed non-priority eligible, but still facing solvency issues—generally in the Critical and Declining Pension Protection Act Zone Status ⁹ —can apply for funds beginning in March 2023.

The SFA program’s initial stipulations faced some pushback from plan sponsors and practitioners. The amount of SFA funds made available to a plan was based on an asset projection using a discount rate that, at the time, far exceeded current bond yields. This liability rate mismatch was addressed in the final rules announced in July 2022 to better support improved funded status projections. A lower discount rate used to project SFA assets consequently allowed for plans to be eligible for a greater amount of SFA funds (Figure 1).

While SFA funds are still required to be segregated from non-SFA funds in pension portfolios, previous requirements about their allocation were also modified in the July 2022 update, which removed the stipulation that program funds could only be invested in investment-grade bonds. Final regulations allow for 33% of a plan’s SFA funds to be invested in equities and other growth assets.

Moving Forward, Better Prepared

With the final rule, the Pension Benefit Guaranty Corporation has provided troubled multiemployer pension plans with a much higher likelihood of survival. While asset and funded status projections now look more favorable, chances of survival will be greatest for plans that can employ holistic investment approaches that maximize the efficiency of their strategic asset allocations. Periods of market volatility in 2021 and 2022 have driven home the notion that allocations to traditional assets alone are not enough to achieve adequate portfolio diversification or sufficiently prepare portfolios for market headwinds. In fact, the traditional 60/40 investment portfolio is on pace for one of the worst annual performances in history, returning -21% through September 30, 2022. In such an environment, plans run the risk of having to sell assets at depressed values to make benefit payments.

SFA regulations specify which asset classes can be used by program funds, stipulating a 67% allocation to investment-grade bonds and the rest to equities and other public growth assets. If structured appropriately, relief assets can be used to reduce much of the liquidity risk of the portfolio. A simple bond ladder or a cash with investment-grade bond mix should provide ample liquidity to meet benefit obligations. Another alternative is to use a cash flow–driven investment (CDI) approach, which minimizes liquidity risk using the following structure:

• Purchase specific set of bonds whose coupon and principal cash flows align with the plan’s projected benefit payments.
• Sell growth assets in the portfolio to replenish the fixed income assets as the CDI portfolio starts dwindling in value due to benefit payments.
• Continue this process until all SFA funds are depleted.

While this strategy would greatly reduce much of the liquidity risk in the portfolio, another benefit is that under this approach, the non-SFA portfolio may not be used for many years. This timeframe affords ample opportunity to grow the asset base of the non-SFA portfolio and further increase the chance of solvency.

Illiquid and semi-liquid securities can help increase the likelihood of plan survival. Private investments (private equity, venture capital, and private credit), as well as both public and private diversifiers, have the potential to improve a portfolio’s risk/return profile, leading to increased asset value and likelihood of long-term solvency. By employing these strategies, the non-SFA portfolio can be constructed to achieve a higher return and lower risk than a pure equity portfolio, and much higher return profile than the SFA option (Figure 2). In this example, the portfolio could still employ a modest allocation to Treasuries to help with any capital calls and rebalancing.

Historically, private investments have been an optimal asset class for helping pension plans maximize solvency (Figure 3). As the non-SFA assets will have minimal liquidity needs, assets such as venture capital and long-life private equity can be used at the onset of receiving the SFA funds. Over time, additional allocations can be made into more traditional private equity and, once liquidity needs arise, the portfolio can allocate into private credit. This varied allocation approach can take advantage of longer-life assets early and transition into shorter-life assets over time. If done efficiently, a large portion of the non-SFA portfolio can be invested into private investments with enough liquidity from the rest of the portfolio. Similar CDI strategies can also be used once the non-SFA portfolio begins paying out benefit payments.

Hedge funds, particularly absolute return strategies, represent another potential avenue for plans seeking a better diversification option as they look to the future. Figure 4 depicts how hedge fund strategies can perform well when all other asset classes suffer, such as the post-COVID inflationary period during 2022.

Under the improved SFA program regulatory framework of July 2022, median asset projections now look more favorable for most plans. However, we understand that future market conditions rarely, if ever, follow median return projections. If we develop a probabilistic (or random variable) projection of funded status, more realistic chances of solvency can be estimated. By constructing a well-rounded portfolio, the likelihood of increasing funded status and maintaining solvency is greatly improved.

Conclusion

With the larger asset base provided by SFA funds, the use of private investments and diversifiers by multiemployer pension plans is now not only more feasible but may be necessary to increase the likelihood of achieving long-term objectives. Recent market experience has shown that traditional asset allocations may not be enough to protect even the most conservative portfolios. Multiemployer pension plans should consider using alternative investments to increase returns, help manage risk, and provide diversification. Being able to use the return generation of privates, as well as specialized public and private diversifiers opportunities, can help improve the risk/return profiles of the portfolio, with liquidity needs addressed by cash flow matching. Employing these strategies will help multiemployer pension plans improve solvency to 2051 and beyond.

Footnotes

1. The term “short rebate” refers to the interest income earned by investors that lend out securities for short selling.
2. The Moving Ahead for Progress in the 21st Century Act of 2012, or MAP21, represents the first funding relief since the Pension Protection Act (PPA) of 2008.
3. The America Rescue Plan Act (ARPA) funding relief of 2021 significantly reduces funding requirements by introducing a floor on the interest rates used for discounting liabilities, and a longer amortization period (from seven years to 15 years).
4. The Funding Target methodology is used to determine the plan’s minimum required contributions under ERISA and the Pension Protection Act of 2006 (PPA).
5. See Dan Doonan and William B. Forina, “A Better Bang for the Buck 3.0,” National Institute on Retirement Security, January 2022.
6. Data reflect annualized returns. Japanese equity performance is based on the MSCI Japan Index and DM ex Japan equity performance is based on the MSCI World ex Japan Index.
7. The denominator effect refers to a rise in the proportion of private investments in investor portfolios resulting from public market declines.
8. The American Rescue Plan Act of 2021 (also known as the COVID-19 Stimulus Package) was a $1.9 trillion stimulus bill designed to counter the economic and public health effects of the COVID-19 pandemic. It was signed into law on March 11, 2021.
9. The Pension Protection Act of 2006 required multiemployer pension plans to be certified based on their financial health. The certification of Green Zone plans is considered in good health, Yellow Zone plans is considered endangered, and Red Zone plans is considered to be critical.

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