Capital Publishing Group had one of their financial analsysts, Affan Bin Mahmood, CFA®, catch up with William Kelly, CEO of the CAIA Association. William Kelly is an asset management industry veteran with extensive managerial and boardroom experience. He currently serves as the CEO of the CAIA Association (https://www.caia.org) a global organization committed to education and professionalism in the field of alternative investments. The association currently has over 9,000 members associated with 29 chapters worldwide.
Affan Bin Mahmood produces engaging independent content for Capital Publishing Group's Equity Research department and sources topics for commentary across various Capital Publishing Group brands. For more information on Affan Bin Mahmood, please go to our Staff page.
Q. Last year hedge funds mustered less than half the 11.9 percent return of the S&P 500, according to research provider HFR. It was the ninth consecutive calendar year that hedge funds under-performed the stock market on a net of fee basis. Investors clawed back $110bn from hedge funds last year. What in your view are the reasons for this under-performance?
A. “The global financial crisis is now deep in the investors’ rear-view mirror and a lot has happened since 2008. Most notably, global central banks have put almost $20T of fresh liquidity into the financial markets which has resulted in the perfect storm of near-zero interest rates, asset inflation across the equity markets, and some of the lowest levels of volatility ever experienced in the capital markets. Any hedged strategy that seeks uncorrelated returns will simply not keep pace in this kind of market environment.
Prior to making any mid-course changes in any asset allocation decisions, it is useful to think about exactly what investors’ expectations should be now and over time. The benefit of diversification, by design, is to provide better risk-adjusted returns. It is natural to be disappointed with the lowest performing asset class in your portfolio, but it should not automatically mean that expectations around your targeted asset allocation have not been met. Any rush to these types of conclusions in a market environment such as the one we are currently in should be done carefully and be devoid of emotion and reaction to the latest headlines.
Interestingly and of direct relevance, AIMA and Preqin conducted a study earlier this year whereby they examined the risk adjusted returns of hedge funds for 2016 and also for the 3 and 5 year periods then ended. Specifically, they looked at Sharpe Ratios to examine the returns being earned for each unit of risk taken. Through that lens, the hedge fund indexes actually outperformed the risk-adjusted equity and fixed income returns in each one of the above stated time periods.”
Q. Equity markets are already at their peak, with the DJIA crossing 21,500 mark recently (on June 19, 2017). Given this, how do you see equity based hedge fund strategies performing over the next 3 to 5 years?
A. “By virtually any historic or current valuation metric we are at or very near a level of equity valuations that will not be sustainable absent real economic growth. As central banks start to raise rates and shrink their now massive balance sheets, global GDP and inflation remain low, and the menacing shadow of geopolitical risk looms, there are not a lot of signals for near term upside from here.
It is also interesting and relevant to look at what is going on in active versus passive management, especially as the latter is now being viewed by some as so-called permanent capital. Investors (rightfully) have become very focused on fees in this low interest rate environment, but that should not automatically mean that valuation does not matter. By design, index funds are price takers and large flows into this space have a natural tendency to bid up the price of equities, independent of the underlying fundamentals or other market factors.
I think investors should expect to see a little bit of regression to the mean. If you speak to most market practitioners you will find a strong consensus that we are entering what will be a lower overall yield environment where future expectations for the traditional 60/40 index are expected to fall below 5% before factoring in the impact for inflation.
Beyond rightsizing any outsized and maybe even unrealistic absolute returns, investors should also be taking heed of the corrosive effects of substantial draw-down risks, and that is precisely the very best value proposition for introducing uncorrelated return streams into portfolios. Accessing alternative investments through the prism of informed consent has never been more relevant.”
Q. From a business perspective, the policies of Mr. Trump are viewed quite positively and which is also one reason why equity markets have gone up. Considering these policies, how do you see the Hedge Fund industry being affected?
A. “If you are an asset manager, less regulation versus more is usually a better proposition for growth. So far, in their early days, the Trump administration has shown an interest in either rolling back or examining a lot of regulation that has been put in place post the global financial crisis. There are two sides to the debate as to what this means for the investor. We should not regulate any investor back to a risk-free rate, but the introduction of more sophisticated investment strategies must be accompanied by greater levels of literacy, transparency and education and it is here that our elected officials, regulators and practitioners must work together.
Since the November elections in the US, we have seen an even larger run-up in equity valuations without a big change in underlying fundamentals. Expected tax reform resulting in benefits estimated to be in the neighborhood of $1T is one reason that explains part of this run, but we are almost 200 days post-election and I don't see anything of substance on the horizon. There is also an absence of clarity as to how we will pay for this tax reform out of what is already a high annual deficit replete with substantial entitlement commitments that will be very hard to reform in the near term.
A government is just like a household. We are all entitled to have our dreams and aspirations, but then you have got to take a step back and think about what you can reasonably afford to do in the current environment with many inputs, including a realistic view of earning (or taxing) capacity into the future. Commitments that put a call on future earnings capacity do not go away, rather they put a lien on what we can, or want to do, in the future. These commitments need to eventually be met and that is called reality. This has never been more true than what you can observe in the public pension plan space. The contributions and services of these devoted public employees speak for themselves, but the continuation of making these contractual promises for retirement and health care benefits, without any realistic path as to how they will be funded, should be very concerning to all of us. We would not run our household budget this way, and this kind of rational analysis needs to be made here too.
Legislative reform needs to be balanced, realistic and lasting beyond the term limits of any single elected administration.”
Q. Other than equities, which hedge fund strategies do you expected to perform well going forward?
A. “As an educator, I am not in the business of giving investment advice. Looking at markets through a more value oriented lens is usually a very good approach and one that is espoused by a lot of successful investors such as Warren Buffett. This means buying things that are cheap and/or out of favor. Managed futures is just one such example of a general alternative investment asset class that has underperformed relative to most measures. As volatility and the potential risks of larger draw-downs come back into the market, this is one area perhaps worth a closer look through informed analysis. Investment and operational due diligence is an important part of the approach to any asset class and there are absolutely no exceptions to that rule. The dispersion of investment returns can be enormous in many of these different offerings and strategies, and an asset allocation model needs to go much deeper than simple exposure to very broad labels such as “hedge funds,” “managed futures” and “private equity”.”
Q. A new class of hedge funds, liquid alternatives, have recently been gaining popularity among some investors. What advantages other than increased liquidity do these provide and are there any drawbacks to investing in these?
A. “As a general matter, giving investors more options around uncorrelated asset classes is a good thing, but taking fairly sophisticated strategies and packing them into daily liquidity wrappers might not yield the desired results. Limitations on liquidity, leverage and even in some cases, transparency, rinse out some of the basic value additive tools that make these strategies relevant and highly differentiated in the first place. Investor behavior has been conditioned to always want immediate liquidity, no matter what. Rather than cater to that view, investors and their advisor should always take a step back and look at the duration and intended consequences of the liabilities on their balance sheets. If an individual is 35 or 40 years old and is saving for retirement or starting a college fund for an infant, liquidity should not be the number one concern around diversification. With this kind of horizon, an investor can more easily absorb periodic and expected draw-downs in any asset class without the need to panic or rush out of markets, and/or come back in when it is very late in a cycle. Imagine what the US housing market could have looked like if homeowners were able to sell their properties on a T+3 basis? This is an asset that is likely the largest holding of most households. It is illiquid and often highly leveraged but is looked at very differently than a relatively smaller investment in a mutual fund. Simply put, thoughtful solutions need to supplant pure product proliferation.”
Q. Do you recommend hedge funds for small investors, i.e. people having an investment portfolio of $10K to $50K?
A. “Regardless of size, any portfolio can benefit from greater diversification but asset allocation decisions are dynamic and should not be made in isolation. If the primary purpose of a small portfolio is to serve as an emergency fund, than safety and liquidity must be paramount. Gambling here in the hopes of turning it into something more is reckless and completely outside of the intended goal. If there is a more long-term orientation to a savings plan, then diversification is absolutely warranted. That being said, any investor should look beyond the label and that has never been more true than it is with hedge funds. Hedge funds can be defined as an industry but it is absolutely not an asset class. There are over 10,000 hedge funds, and some can and do provide absolute or relative risk mitigation. There are also many strategies in this space that seek high absolute returns and often times can employ very high degrees of leverage and volatility. Dispersion of investment returns can be enormous and again here due diligence of portfolio process and expected returns are of paramount importance. Asset allocation decisions should be thought about through a process that looks at discrete and uncorrelated risks buckets much more so than a model that seeks exposure to very broad labels such as equities, hedge funds or bonds. Additionally, it is important to note that many investors with investment portfolios in the range you’re describing may not be able to access many hedge fund or private equity managers, who have much higher minimums, lock-up policies that may not make sense for a smaller investor, or otherwise fall under regulatory regimes that require investors to meet minimum liquid asset levels or provide other proof of “sophistication.” It is precisely for the kind of investor you’re describing that many liquid alternative products have been brought to market, but as I mentioned earlier, investors need to know what they are, and aren’t getting, when they’re considering such a product.”
Q. So, what you are saying is that it does not depend on the size of your portfolio but instead on how educated you are with respect to different investment options?
A. “As a general matter, yes… But the “you” can and should also include trusted advisors, enlightened regulators and policy makers, and a balanced financial media. Financial literacy and investor education levels need to come up and every market participant can and must make this a priority.”