American economist Paul A. Samuelson offered the dictum that the asset markets are “micro efficient” but “macro inefficient.” That is, the hypothesis that markets are efficient works much better for individual stocks than it does for the market as a whole. If you accept the dictum of the Nobel Prize winning Samuelson as true, it would stand to reason that investment managers that attempt to consistently generate alpha by leveraging their skills at picking stocks are playing a loser’s game. 

The efficiency that exists in the market at the micro level can largely be attributed to the success of hedge funds and their ability to attract capital. As money has flowed into hedge funds, these firms invested heavily in research talent to identify securities that offer potential for outsized gains. The surge in research investment has largely contributed to the micro efficiency noted by Samuelson. Beyond the research glut, the high volume of trading activity in hedge fund portfolios has further contributed to efficiency at the micro level. The market volume necessary to arbitrage GM and Ford is far less than that needed to arbitrage the Japanese market under Abenomics. In sum, hedge funds have killed the golden goose by throwing so much money at research that they created a market that is so efficient that generating alpha has become increasingly difficult.  

Given the performance challenge facing hedge funds due to efficiency at the micro level, not to mention a fee structure that few managers can justify, many defined benefit plan sponsors are increasingly seeking alternatives to hedge funds. Global tactical asset allocation (GTAA) strategies, otherwise known as multi-asset strategies, provide diversification across a broad range of asset classes, with a far lower fee structure, greater liquidity and transparency than hedge funds, and offer an optimal way to gain equity-like returns with reduced volatility. 

GTAA strategies take a macro view across global markets and provide top-down exposure, allowing them to capitalize on the inefficiencies that exist at the macro level. Like most hedge funds, multi-asset strategies focus intensely on downside protection but unlike hedge funds, aim to tactically exploit meaningful inefficiencies between markets and asset classes through the use of top-down, macro analysis. In addition, they tend not to be burdened by high fees, illiquidity and complexity. Plan sponsors may benefit greatly by allocating to multi-asset strategies in their portfolios, as they provide similar benefits as those that have made hedge funds so popular with institutional investors (namely low correlation to stocks and downside protection).

An analysis by Nomura Global Markets Research, provides further support for GTAA strategies relative to hedge funds.  Nomura tracked the performance of a representative hedge fund of funds over the 2007 to 2013 period and compared this performance to the S&P 500 index. What this analysis discovered is startling. As hedge funds seek to juice their returns through the use of leverage, Nomura analyzed the performance of this representative fund-of-funds and compared it to the S&P 500 index de-leveraged after all fees. As the table below demonstrates, the fund-of-funds generated nothing more than beta, but charged quite a hefty fee to do so.

In sum, the money hedge funds have poured into research and analysis, together with the high portfolio turnover common to hedge funds, has milked the inefficiencies out of the market at the micro level.

As plan sponsors increasingly look to generate alpha in this ever-changing market environment, they may want to consider multi-asset strategies as a strong alternative to hedge funds, as they allow for more liquidity and transparency in a portfolio, all with a much more reasonable fee structure.

By Hayes Miller, head of asset allocation for North America at Baring Asset Management  

Baring Asset Management is an international investment management firm based in London with investment skills, clients and business locations spanning world markets. Their investment competency encompasses developed and emerging market equity, fixed income and multi-asset portfolio management services offered to institutions. Worldwide clients include public and corporate pension plans, government agencies, financial institutions, charitable organizations, mutual funds and private individuals.