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More stable and better Returns through Hedge Funds.

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The return of inflation poses significant challenges to traditional portfolios of equities and bonds - now and in the coming years. Due to the lower return prospects of both asset classes and rising correlation, professional investors should set their sights on alternative investments to weatherproof their portfolios again. The following article explains why hedge funds deserve a place in the allocation and what advantages they could offer.

Changing tides in the capital markets

How beautiful the investment world of yesterday was: equity and bond markets both delivered above-average returns, on top of that, the combination of both asset classes delivered very good diversification due to negative correlation. A simple 60/40 portfolio was therefore sufficient to generate attractive returns; and with that low volatility. However, due to recent strong monetary expansions, rising commodity prices and disruptions in global supply chains, investors are now faced with the challenge of rebalancing their portfolios to account for increased inflation risk. This is uncharted territory for many portfolio managers: after all, inflation has not been a serious issue since the 1980s.

The first half of 2022 should therefore have been a wake-up call for many market participants: The classic portfolio, consisting of 60% equities and 40% bonds, suffered the heaviest losses since 1932 due to simultaneously falling equity and bond markets: Around 16% price loss was recorded at the mid-year.

Figure 1) Performance of S&P 500 (SPY) and US Treasury Bonds (TLT)
The simultaneous collapse of the equity and bond markets in the first half of 2022 resulted in the largest price loss for the 60/40 Portfolio in several decades.
Source: TradingView

Rising inflation uncertainty affects many areas

In macroeconomic terms, the new inflation regime is having a whole host of effects: On the one hand, high or strongly fluctuating inflation makes it more difficult for households and companies alike to distinguish absolute price changes from relative price changes, which increases inflation uncertainty. The general level of interest rates and the volatility of interest rate developments increase as a result. With greater uncertainty about future inflation developments, monetary policy becomes less predictable for both market participants and economic agents. The risk of a negative monetary policy surprise thus also increases. Due to these factors, uncertainty about economic growth consequently also increases, which ultimately leads to lower GDP growth. A look back at the 1970s, which were characterised by stagflation, shows that the buy-and-hold strategy, which worked well in the past, may no longer work. Instead, active timing and asset class rebalancing may be called for.

Figure 2) S&P 500 and inflation rate (1968-1979)
Source: TradingView

Comparison of returns of traditional and alternative asset classes

Historical data shows that periods of high inflation and elevated inflation expectations have a major impact on capital markets, especially if the trend persists over an extended period of time. A comprehensive study compares annualised real returns for each asset class and active strategies during periods of high inflation and other periods. The results for the period from 1926 onwards speak a clear language:

  • Traditional investments perform poorly in inflationary phases [1]
  • On average, equities generated an annualised real return of -7%
  • Ten-year government bonds delivered an annualised real return of -5% on average
  • A 60/40 portfolio achieved an annualised real return of -6% on average

Figure 3) Asset and strategy performance in inflationary and non-inflationary periods (USA).
Traditional asset classes deliver negative real returns in inflationary periods. In contrast, active strategies such as trend following and alternative assets such as commodities benefit.
Source: Henry Neville, Teun Draaisma, Ben Funnell, Campbell R. Harvey, Otoo van Hemert "The best strategies for inflationary times".

The development of alternative investments and active strategies, on the other hand, is quite different. Commodity investments in general have a significantly positive inflation beta and delivered high real returns in times of high or rising inflation. This is especially true for energy commodities - a development that can also be observed in the current market situation. Among active strategies, trend-following strategies performed well, based on all asset classes. This is due to the fact that inflation shocks do not mark overnight events but rather longer episodes and thus provide a good basis for trend-following models.

How does the equity-bond correlation react to increased inflation?

It is not only the weak performance of traditional assets that causes investors headaches in inflationary phases - there are also unfavourable shifts at the correlation level that affect the risk-return ratio of the portfolio. The following chart shows the rolling correlation of the two most important asset classes, equities and bonds, during three periods:

  • Between 1950 and 1965, the correlation between equities and bonds was -0.16
  • Between 1965 and 2000 the correlation increased significantly to +0.28
  • In the two decades between 2000 and 2020, the correlation fell again significantly into negative territory (-0.29)
Figure 4) Stock-bond correlation (USA)
Phases with higher inflation rates cause the stock-bond correlation to shift from negative to positive territory. The diversification effect thus decreases significantly.
Source: PGIM Quantitative Solutions [2]

The increase or decrease in the correlation between equities and bonds depends on numerous factors. Phases such as those from 1950 to 1965 and 2000 to 2020 were characterised by low and stable inflation rates and the risk-free interest rate. From the monetary and fiscal policy side, a certain predictability and continuity could be observed. All these factors provide for a negative correlation between equities and bonds. The reverse development, however, provides for a shift of the correlation into positive territory: surprises from the monetary policy side, unsustainable fiscal policy, increased and volatile inflation and interest rate levels as well as shocks on the supply side.

The increase in the correlation between equities and bonds ensures higher volatility in the portfolio due to the weaker diversification effect and thus a lowering of the Sharpe ratio. Figure 5 shows schematically how the Sharpe ratio changes on the basis of the different correlations and the respective bond weighting.

Figure 5) Change in the Sharpe ratio with different correlations
The higher the bond weighting, the more the Sharpe ratio of the overall portfolio falls when the correlation shifts from negative to positive territory.Note: The performance of the portfolio is based on 1000 simulated monthly returns with monthly rebalancing. It is assumed that equity and bond returns are normally distributed. Expected annualised returns: Equities 10% p.a., bonds 5% p.a., annualised volatility 12% and 6% p.a. respectively.
Source: PGIM Quantitative Solutions [2]

Hedge funds as a source of diversification and returns

Low return prospects and adverse changes in the correlation between and equities and bonds are increasing the pressure on the classic 60/40 portfolio - not least due to the historical slump in the first half of 2022. The fact that the majority of portfolios have a downside inflation bias, i.e. tend to benefit from low or falling inflation rates, represents an open flank for the future. In order to be able to guarantee future return targets at an acceptable risk, it is therefore worth looking at alternative investments such as hedge funds.

In order to ensure future return targets at an acceptable level of risk, it is worth looking at uncorrelated investments such as hedge funds.

Hedge funds represent investment vehicles whose active strategies aim to generate attractive returns over the long term - demonstrably independent of the equity, bond or commodity markets. They pursue a wide variety of strategies and use leverage, short selling and derivatives to control exposure and manage risk. Examples include market-neutral equity strategies, global macro or managed futures.

Figure 6: Asset Correlation Map (2011-2021)
Source: Guggenheim Investments [5]

Each sub-category offers investors access to different sources of return. The figure below shows the respective hedge fund categories and the statistically significant factors that act as drivers for the respective returns. The Multi Strategy category offers a particularly broad selection of factor sources: These include a positive beta to the factors Market, Momentum and Low Volatility, while there is a negative beta to Value, Quality and Short Rates Trend.

Figure 7) Factors as return drivers of different hedge fund categories
Source: Vanguard [3]

The higher risk-adjusted returns of hedge funds compared to equities and bonds make the former an attractive addition and can substitute for some equity or bond exposure. Figure 8 compares different performance measures of equity market neutral and multi-strategy hedge funds versus equities and bonds over the period 2000-2021.

Figure 8) Equity Market Neutral and Multi Strategy vs. Equities and Bonds (2000-2021)
Market neutral and multi-strategy hedge funds outperformed equities or bonds on a risk-adjusted basis between 2000 and 2021.
Source: Schroders [4]

Moreover, they play a stabilising role in the portfolio, especially in phases of sharp market declines. In the equity crash from September 2000 to March 2003, these two categories yielded significant gains, while equities lost massive amounts of value. Also during the financial crisis from 2007 to 2009 or during the Covid crash, hedge funds cushioned the losses of the stock market.

Intalcon Alpha for Impact Global Fund

To demonstrate the concrete advantages of allocating to a successful hedge fund, we present our Intalcon Alpha for Impact Global Fund below. The offshore fund has been traded for more than 10 years and is based on a mix of discretionary and systematic trading strategies. Different asset classes such as shares, ETFs as well as index, interest and commodity futures are traded. The equity portion is always kept above 51%, while the net exposure is managed with the use of index futures. Half of the time, the fund is market neutral. All traded instruments have high liquidity, allowing investors to make weekly deposits or withdrawals.

At the heart of the fund is a mix of different approaches, which are traded very actively and at different time levels and both long and short, thus enabling attractive returns - regardless of the course of the stock, bond or commodity market. The analysis of the price behaviour and different price patterns resulting from certain constellations of supply and demand acts as a basis for decision-making. This evidence-based approach also offers advantages on the risk side: Each individual position is hedged by means of stop orders, thus ensuring that drawdowns are kept as low and short as possible. In addition, exposure limits are used for certain markets. In addition, all positions are always considered in terms of their correlations with each other and adjusted to the respective market situation in order to minimise risks.

Figure 9) Risk-return diagram for Intalcon Alpha for Impact Global Fund (5 years).
Source: Intalcon

This approach has paid off since the fund's inception: In the BarclayHedge ranking, for example, the Intalcon Alpha for Impact Global Fund occupies a top position in the "Multi Strategy" category (see figure).

Figure 10) BarclayHedge ranking (Multi Strategy Hedge Funds).
Source: BarclayHedge

Addition of 10% doubles the Sharpe Ratio

The high returns of the Intalcon Alpha for Impact Global Fund and the very low correlation to equities, bonds and commodities make the Multi Strategy Fund an attractive addition to a traditional portfolio. The simulation on the chart below shows the performance of a 60/40 portfolio (black) since 2017, compared to a portfolio mix where 10% of the 60 portfolio was allocated to the Intalcon fund. The improvement in risk-return ratios clearly shows the benefits.

Figure 11) Allocation to the Intalcon Alpha for Impact Global Fund
An allocation to the Intalcon Alpha for Impact Global Fund in the amount of 10% delivered significant additional returns for the overall portfolio compared to the traditional 60/40 portfolio in the past: The Sharpe Ratio almost doubled from 0.83 to 1.58. Status: 30.4.2022
Source: Intalcon

The tble below illustrates that with an addition of 10% to the Intalcon Alpha for Impact Global Fund, an almost doubling of the annualised return was achieved - with a roughly unchanged volatility. The Sharpe Ratio could be increased from 0.83 to 1.58.

Future-proof portfolios rely on hedge funds

The changing tide in the capital markets exposes the weaknesses of many portfolios that have so far been primarily geared to low or falling inflation rates. The increasing correlation between equities and bonds requires a rethink in allocation. Investors looking for other sources of risk to future-proof their portfolios can hardly avoid hedge funds. Through different long/short strategies, trend following and the use of commodities, hedge funds can not only hedge inflation risks but also mitigate the impact of low yields on expected returns. They act as excellent providers of diversification but also as "risk mitigators", making them a valuable addition to traditional portfolios.

[1] Henry Neville, Teun Draaisma, Ben Funnell, Campbell R. Harvey, Otoo van Hemert “The best strategies for inflationary times”
[2] PGIM, "US stock-bond correlation. What Are the Macroeconomic Drivers?"
[3] Vanguard, "The wrapper matters: Comparing liquid alternatives and hedge funds"
[4]Schroders, "What`s the alternative to the classic 60/40 portfolio?"
[5] Guggenheim Investments,

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