Are The Capital Markets Headed For A Major Correction And Will Hedge Funds Help Or Hurt? by Donald A. Steinbrugge, CFA
Major corrections of the capital markets are a risk that investors always need to consider. The question is not if, but when will it happen. Investors need to consider: What is the probability of it happening in the near future? How big will the correction be? How long will it last? Am I prepared to ride it out, or is it game over if it happens?
Most investors are used to the capital markets rebounding fairly quickly from a market correction. However, the worst sell-off of the US stock market began in 1929 and resulted in a decline of almost 90% that took 23 years to recover. The Nikkei index hit an all-time high of approximately 39,000 in 1989 and more than 26 years later is still below half its peak.
Has the probability of a major sell-off increased?
We have recently heard some of the top investors in the world give very negative comments on their outlook for the capital markets, including: Jeffrey Gundlach speaking with Business Insider said “The artist Christopher Wool has a word painting: ‘Sell the house, sell the car, sell the kids.’ That’s exactly how I feel – sell everything. Nothing here looks good.” Bill Gross stated on Twitter, “Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.”
Many people believe there is an unsustainable bubble in the fixed income markets. Not only have sovereign interest rates declined to record lows, but spreads have tightened as investors reach further and further for yield. Fitch Ratings estimates that as of mid-August, $13.4 trillion of bonds were trading at negative interest rates representing approximately a third of all outstanding global debt. Governments are issuing debt at negative interest rates while running up unsustainable deficits. This does not include unfunded liabilities for public welfare programs such as retirement and healthcare. Most experts agree these programs are unsustainable in the long term. It is difficult to predict when capital market bubbles will end, but typically the longer they go on, the worse the final outcome.
Strong equity returns are being driven primarily from expansion of PE multiples in an environment of very low global GDP growth and stagnant earnings growth. Brexit, weakness in China’s economy and potential defaults by weaker countries within Europe are quickly shaken off. Investors justify these elevated equity prices based on the low interest rate environment, which has caused the correlation between the equity and fixed income markets to rise. The massive stimulus since 2008 by monetary authorities around the world has had less and less impact on global growth and leaves these organizations with very little dry powder to prevent a deeper and more prolonged recession than experienced in 2008. In addition, these dynamics increase the probability of a major market sell-off as central banks continue to artificially prop up markets.
Are Investors prepared?
Most institutional investors use modern portfolio theory to build “efficient portfolios” that maximize forward expected risk-adjusted returns for a multi-asset class portfolio. In order to calculate the optimal asset allocation they use assumptions for return, volatility and correlations (relative to movements of various asset classes) for each asset class in the model. Unfortunately, during market sell-offs these models break down. Not only does volatility spike, but more importantly, correlations between managers and asset classes are dynamic and rise significantly creating much more tail risk than perceived in investor’s portfolios. Most public pension funds are heavily under-funded and a prolonged sell-off in the capital markets would leave many unable to pay benefits without increased funding at a time when the municipality can least afford to make additional payments.
Should investors hold more cash?
Most investors are terrible at predicting the directions of the market and this strategy requires two decisions: when to get out and when to get back in. Investors typically get whipsawed by letting their emotions drive their investment decisions by buying near market peaks and exiting near market bottoms. A much better strategy is to build out a diversified portfolio that can ride through market turbulence. This requires understanding and being comfortable with the tail risk of the portfolio and avoiding the need to sell at market bottoms.
Can hedge funds help?
Recently, the hedge fund industry has been heavily criticized for poor performance of hedge fund indices. 2016 has been one of the worst years ever for performance of hedge fund indices relative to the stock and bond markets, but it does not tell the whole story. Hedge Fund indices are biased to do poorly, because they consist of an amalgamation of investment strategies and a broad array of hedge fund managers. The hedge fund industry has low barriers to entry and as a result has swelled to over 15,000 managers, most of whom are not very good. It is similar to the mutual fund industry where a majority of funds underperform the indices they are expected to outperform.
It is important to remember that hedge funds are not an asset class but a fund structure consisting of numerous investment strategies. The performance of hedge fund strategies and managers varies greatly along with their correlations relative to the capital markets. Successful investing in hedge funds requires analyzing the strengths and weaknesses of each hedge fund strategy as well as the managers within each strategy. Some strategies have the potential to have low and possibly negative correlation to the fixed income and equity markets during a market sell-off. In addition, unlike holding cash yielding close to a zero percent interest rate, many hedge fund strategies have the potential to generate decent returns. Below are listed of some these diversifying strategies:
Commodity Trading Advisors (CTAs) These includes a lot of different strategies, but are dominated by systematic trend following managers that identify price trends across multiple asset classes, including currencies, commodities, equities and fixed income. Trend following has been one of the top performing strategies over the past few years and has worked well over long periods of time including up double digits in 2008. A pure trend follower does not care about fundamental analysis or valuations of markets. Their correlation to the capital markets on average is very low, however many have dynamic correlations that are positive in up markets and negative in down markets. Investors should consider building out a diversified portfolio of CTA’s consisting of many different trend following and non-trend following strategies.
Private Lending – There are wide differences in credit quality and yields of funds within the private lending space, but most of these funds are taking advantage of the fact that it is difficult for small and mid-sized companies to get financing from traditional lenders. As a result, yields are much higher typically for private debt than traditional marketable fixed income securities. Many of these funds hold their securities at book and only adjust market value if there is an impairment to credit. This gives them a very stable uncorrelated performance as long as the liquidity provisions of the fund match the underlying securities and there is not a significant impairment to the credit quality