The fourth quarter of 2018 is truly a special one. While “Tis the Season to Be Jolly,” the market has been more of a Grinch. The S&P 500 has sold off more than 12% since Q4 began (through December 18, 2018), and hedge fund strategies are beginning to show signs of life again with the HFRX Global Hedge Fund Index off by -5.4% over the same period. It’s time to ask the question again—should investors allocate to hedge fund strategies? Before we answer this question, let’s try to demystify some of the popular claims about diversification.
Claim 1: Hedge fund strategies are not a good diversifier because they are highly correlated with equities
It’s true the recent correlation between hedge funds and equities, using the HFRI Fund of Funds Index and the S&P 500 as proxies, respectively, is as high as 80% over the past 10 years. However, the past 10 years may also be an “abnormal” period, as we have enjoyed the benefits of the post-financial-crisis market rally. Looking over the longer history, the correlation between hedge funds and equity markets is much lower. Before 2008, the average correlation between hedge funds and equities was ~0.5, while after 2008, the average has risen to ~0.75.
Rolling 36 Month Correlation to the S&P 500
Source: Bloomberg, from 12/31/1992 to 11/30/2018 . Fixed income (FI) is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, equities are (EQ) represented by the S&P 500 Index, hedge funds are represented by HFRI Fund of Funds Index (HFRIFOF). Past performance is not indicative of future results, which may vary. An investment cannot be made directly into an index.
Claim 2: Fixed income is negatively correlated with the equity market
This may seem like a universal truth and the golden principle behind modern portfolio construction (theory). Yet, if one looks a bit further back in history, it won’t be very hard to find prolonged periods of positive correlation between fixed income and equities. The relationship between fixed income and equities is complicated. The main drivers for fixed income return, such as interest rates and inflation, could be either good or bad for equities, depending on the impact upon economic growth. For example, right after the trough of the great financial crisis, fixed income and equities enjoyed positive correlation for ~3 years, as monetary easing spurred an equity market recovery. That relationship reverted after 2012 as rate-hiking pressure increased to cause the fixed income sell-off in 2013, while equities continued to enjoy the prolonged rally.
Claim 3: A conservative portfolio with a high allocation to fixed income would have low correlation to the equity market
If the correlation between fixed income and equities is not stable, it’s hard to expect a portfolio with a high allocation to fixed income to always maintain a low correlation to equities. In fact, a hypothetical conservative portfolio, with 70% allocation to fixed income and 30% allocation to equities, currently has a correlation of ~80% to equities, which is on par with the correlation between the HFRI Hedge Fund Index and S&P 500 Index.
Why does the 70/30 portfolio have such a high correlation to equities, even when the allocation to fixed income dominates the portfolio, and the current correlation between fixed income and equities is hovering around zero? Thanks to the prolonged, low-interest-rate environment and equity market rally, equities have been the outsized driver for portfolio returns, regardless of their percentage weighting in the portfolio.
Rolling 1 Year Returns
Source: Bloomberg, as of December 18, 2018. Fixed income (FI) is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, equities (EQ) are represented by the S&P 500 Index. Past performance is not indicative of future results, which may vary. An investment cannot be made directly into an index.
Heading into the new year, the only certainty is that the market creates uncertainty. As correlations shift through time, fixed income may not be the universal cure for diversification, and a hedge fund strategy could still be a good diversifier, not only for equity risk but also for fixed income risk. History shows a hedge fund index outperforms fixed income 91% of the time during months of large rate sell-offs. As we are facing headwinds from both equity market volatility and rising interest rates, ‘tis the time to consider a hedge fund strategy again, if suitable.
Returns for Monthly Periods When the 10-Year Yield Rose at Least 20bps
(January 31, 1990 – September 30, 2018)
Source: Bloomberg, data analysis from January 31, 1990 through September 30, 2018. Fixed income (FI) is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, hedge funds are represented by HFRI Fund of Funds Index (HFRIFOF). Past performance is not indicative of future results, which may vary. An investment cannot be made directly into an index.
The S&P 500® Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.
The HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage.
The Bloomberg Barclay’s U.S. Aggregate Bond Index covers the investment-grade, US dollar–denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS, ABS, and CMBS, with maturities of no less than one year.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.
This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, located at 51 Madison Avenue, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC and serves as the advisor to the IndexIQ ETFs. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.