Interview: William Kelly, chief executive officer, CAIA Association
Hedge fund investment into emerging markets were driven by low equity valuations, increased local volatility, and a low global interest rate environment during the year where the Indian market stood out. The HFR Emerging Markets: India Index was up almost 26 per cent through July of this year. However, a combination of factors, like the Fed rate hikes, geopolitical risk, and the likelihood of a strengthening dollar relative to most emerging market currencies could put pressure on these markets in the period ahead, says William Kelly, CEO, CAIA Association, in an exclusive interview with Ashwin J Punnen of Financial Chronicle. Excerpts:
How has hedge fund performance been this year; have the returns been better than what has been seen in traditional funds?
Investors should always take a long-term view of markets, asset allocation decisions, and their related risk tolerance. With that caveat, the first half of 2017 has been a decent period for the very broad category of hedge funds. According to Hedge Fund Research (HFR), their Fund Weighted Composite Index was up 1.2 per cent in July, which represented the ninth consecutive monthly gain, along with a growing trend of 16 out of the last 17 months showing positive absolute returns. Net asset flows into this space were positive and total assets in the hedge fund space sit just north of the $3 trillion mark. This was all done in the backdrop of continued low volatility and low rate environment leading to a continued risk-on approach to most equity trading strategies.
Have high stock market valuations hit the returns on hedge funds?
As a general answer, ‘yes.’ The very nature of a hedged strategy is to provide better risk-adjusted returns over long market cycles. This means accepting lower volatility than a pure equity strategy (or index) whereby some of the upside capture is sacrificed in return for lower drawdown risk. Ultimately, this should result in better risk-adjusted returns over time. The market environment post-the global financial crisis has, for the most part, been a one-sided trade where new highs are being seen in many equity markets accompanied by very low levels of market volatility. The investor, in some cases, has forgotten what drawdowns feel like and is consumed with the thought of getting every basis point of upside capture. It would appear that we are entering a phase of the market where caution and a greater emphasis on asset allocation and diversification will be even more important.
This year saw huge outflows from emerging market funds; what was the impact on hedged strategies in this space?
The fund flows into emerging market equity (and bond funds) were actually consistently strong and positive throughout Q2 and Q3 of this year. Mid-August brought an abrupt reversal in this trend, thanks to Kim Jong Un, Donald J. Trump, and other catalysts for geopolitical instability, which quickly dampen downs risk appetites in many of these regions. Interestingly, this has been a very strong year for hedged strategies in the emerging markets space as witnessed by the HFR Emerging Markets Index which is up almost 14 per cent through July of this year. Low(er) emerging market equity valuations, increased local volatility, and a low global interest rate environmen t were all catalysts, and markets such as India were even stronger where the HFR Emerging Markets: India Index was up almost 26 per cent through July of this year.
Are high fees becoming a deterrent for hedge fund investors and do you think fees will come down in the future?
Fees are clearly top-of-mind for all investors, especially in a low rate environment. This is true from the lowest priced indexed and ETF funds, all the way up to the carried interest fees that are seen in many hedged and private capital strategies. Investors should always be willing to pay a fair price for alpha and for some limited capacity, high intellect, highly differentiated strategies, a so-called 2-and-20 model is still a fair deal. Conversely, they should pay very little for specific beta. The hedge fund space has grown from about $100 billion to over $3 trillion in the last 20 years and there are now almost 15,000 fund offerings in the marketplace, according to Preqin. Operational and investment due diligence across this industry has never been more important, and that point relates to all aspects of a particular strategy, including fees.
How is the alternative investment fund industry emerging globally in this uncertain time?
The investment world seems to be intent on a two-season approach to the market, where it is described as either bullish or bearish with not many descriptors in between. Investors will continue to be better served to think about the impact of these extremes, especially when you face the darker side of a market cycle and the intendant drawdowns that come with it. Markets are always going to be uncertain and a well-diversified portfolio is the very best defence. Timing your way in, out and back into uncertainty has never proven to be a winning strategy for anyone.
What are the major risks you foresee for the global markets, especially equities in emerging markets like India, in the backdrop of the US Fed rate hikes?
As a general rule, higher yields in markets like the US make assets riskier and emerging markets less attractive in the short- to medium-term. The related capital flows tend to be large relative to these local economies, so flows in either direction are more amplified and have a greater impact. Many emerging markets have been net recipients on the positive side of this trade for the most of this year up until August. The combination of Fed rate hikes, geopolitical risk, and the likelihood of a strengthening dollar relative to most emerging markets currencies will continue to put pressure on these markets in the period ahead.
Are traditional assets classes less risky than alternative assets?
All investors will be much better served to think about risk as an asset to be managed rather than a four letter word. A quality asset or product offering must have a stated investment process and policy that is repeatable across market cycles. If that is in place, an informed and educated investor or practitioner should be able to define and measure the risk characteristics individually and in concert with other holdings in a broader portfolio. Assuming you understand the overall risk tolerance of your investor, the rest of the pieces should more easily come into focus. The overall allocation to traditional versus alternative assets should never be a predefined input.
What are the benefits of alternative investments and how should a retail investor approach traditional mutual funds versus hedge funds as investment choices?
The biggest benefit of an asset class is the uncorrelated nature of the risk premia that it brings into your portfolio. In a previous generation, that tool kit consisted mostly of stocks, bonds and cash with a substantial “alternative” asset allocation, which was the homestead. This latter asset was never really looked at as alternative but typically had a reasonably low and accessible entry point, was highly leveraged and illiquid in the near term, and , if held for 30 years or more, typically resulted in a very decent return on your investment. Sadly, the housing market is not what it once was, but the investment offerings are much more broad and diverse than anything seen in prior generations. Investing is a long game and just like it was for our parents, illiquidity and leverage may not be bad things. Get started early, educate yourself, and stay invested and informed.