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Economic and Market Commentary

When High Alpha Met Low Beta

Max Gelb, Jerry Tsai
A closer look at performance across hedge fund styles.

Summary

  • An in-depth analysis of hedge fund performance demonstrates that, over the past 15 years, lower-beta hedge fund styles have generally achieved higher alpha, aligning with investors' objectives of maximizing returns and diversification.
  • Within the hedge fund landscape, multi-strategy, macro, and trend-following strategies have delivered meaningful alpha while maintaining lower exposure to traditional market betas.
  • The persistence of heightened market volatility may further extend this long-term trend, increasing the appeal for hedge fund strategies that offer the potential for both meaningful defensiveness and alpha.

More specifically, investors have historically tended to seek low beta strategies to diversify traditional asset classes and high alpha approaches in seeking to generate significant excess returns after controlling for traditional market exposures. Although many may assume a trade-off between alpha and diversification potential, that hasn’t been the case: Over the past 15 years, lower-beta hedge fund styles have realized higher alpha.

There are many potential explanations for this counter-intuitive result and each strategy has its own story (see our Featured Solution from March, “Modern Macro,” for a deeper dive). However, one pattern that emerges is that strategies with stronger “crisis alpha” during equity market drawdowns – precisely the scenario investors fear today if recession strikes – have also generated the highest long-term alpha.

Hedge fund strategy performance in 2022 provides the latest striking example. In 2022, while broad hedge fund indices declined 4.1% and $55 billion of capital fled the industry, lower-beta strategies such as multi-strategy, macro, and trend-following delivered positive performance and much-needed diversification.

Widening the aperture, hedge fund industry assets have doubled from $1.9 trillion in 2007 to $3.8 trillion today, despite cumulative net flows of only $42 billion. In other words, hedge fund assets have seemingly grown steadily thanks primarily to long-term performance, but investors need to look under the hood to evaluate which strategies are driving the growth and where capital is flowing. For example, long/short equity has shrunk from 37% to 28% of hedge fund assets since 2007, whereas relative value, macro, and event-driven categories have all grown.

Looking forward, many investors are asking which hedge fund styles are more likely to prosper in an environment of heightened volatility and prolonged higher interest rates to combat inflation (see our Cyclical Outlook from April, “Fractured Markets, Strong Bonds”).

Our framework for evaluating the historical performance of underlying strategies helps explain these trends. As in 2022, periods of high volatility have often coincided with stock market weakness – punishing hedge fund strategies with higher equity beta relative to lower-beta strategies including trend-following and macro.

Winning on both fronts: Positive alpha and increased diversification

The appeal of hedge funds has generally relied upon alpha generation and diversification from traditional asset classes. These are easily quantified with a simple model that regresses hedge fund returns against four major asset classes (equity, interest rates, credit, and commodities). The results show what proportion of a hedge fund’s historical returns is explained by traditional betas versus alpha.

It turns out that over the 15 years ending December 2022, strategies with lower beta to traditional markets – such as multi-strategy, macro, and trend-following – have also generated higher alpha (see Figure 1). This is a compelling “double-whammy” for allocators. Moreover, these results highlight the potential danger of evaluating hedge funds based on total returns alone. For example, a higher-beta strategy may have a greater total return than a lower-beta strategy during a bull market, but the composition of the lower-beta strategy’s return may have significantly more alpha. In a total portfolio context, investors are understandably unwilling to pay hedge fund fees for returns that can be replicated in traditional liquid markets.

 Figure 1 is a chart which shows that lower-beta diversifying strategies have realized higher long-term alpha than long/short equity. More specifically, the chart illustrates what proportion of historical returns for six hedge fund strategies is explained by traditional betas versus alpha over the 15 years ended December 2022. The y-axis shows annual alpha; the x-axis shows the percentage of risk explained by traditional betas. As noted in the text, this analysis is based on a simple model that regresses hedge fund returns for four major assets classes – equity, interest rates, credit, and commodities. Trend-following and macro hedge fund strategies performed best during the period. Trend-following had alpha of about 5.5% with close to 0% of risk explained by traditional betas; macro had returns slightly above 2% with about 15% of risk attributable to traditional betas. Other strategies fared less well: multi-strategy hedge funds generated returns of about 2.5 percent with nearly 60% of risk explained by traditional betas; relative value had returns of about 2% with nearly 80% of risk explained by traditional betas; event-driven strategies delivered annual returns of about 1% with more than 80% of risk due to traditional betas; long-short equity had negative returns of just under 1% with about 90% of the risk explained by traditional betas. PIMCO and Bloomberg are the sources of the data. 

Cyclical outlook favors lower-beta diversifiers

For investors reconsidering their hedge fund allocations, we believe it is critical to assess how the risk of elevated volatility and interest rates could affect various hedge fund strategies. As Figure 2 shows, lower-equity-beta strategies such as trend-following and macro (which had betas of -0.10 and 0.07 since December 1999, respectively ) have done better in periods of high volatility when stocks tend to struggle. In addition, trend-following and macro have outperformed during higher cash-rate regimes – likely, in part, because those strategies have more unencumbered cash available to invest at higher market rates.

Figure 2 presents two bar charts which illustrate that neither high volatility nor high interest rates on cash have been a friend to long/short equity performance over the 15-year period ended December 2022. The left-hand side bar chart shows the annual excess return in high vs. low-volatililty regimes, whereas the chart on the right side depicts the annual excess return in high vs. low cash-rate regimes. Long/short equity’s higher equity beta (a trailing 15-year beta of 0.5) creates a headwind in volatile periods when stocks tend to struggle. In contrast, low-equity-beta strategies such as trend-following and macro (which had trailing 15-year betas of -0.04 and 0.07, respectively) have done better in periods of high volatility than low volatility. In addition, trend-following and macro have outperformed during higher cash-rate regimes – in part because those strategies have more unencumbered cash available to invest at higher market rates. PIMCO and Bloomberg are the sources of the data. 

Follow the trend

The data indicate that the composition of investor hedge fund portfolios is changing – and for good reason. Investors are discerning about where they will pay hedge fund fees, and are gravitating toward styles that are hitting on both alpha and diversification objectives. Elevated volatility and interest rates may prolong this long-term trend, increasing the demand for strategies with superior defensiveness and alpha potential.

1 Performance proxied by the HFRI Fund Weighted Composite Index and flows proxied by total industry data from HFR.

2 Proxies: Trend-following = SG Trend Index; macro = HFRI Macro Index

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Max Gelb
Product Strategist
Jerry Tsai
Client Solutions and Analytics

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