Global Investment Strategy Global Investment Strategy Report June 19, 2017 Justin Lenarcic Global Alternative Investment Strategist Weekly market insights from the Global Investment Strategy team» The current trailing 12-month hedge fund-of-funds return is more than three times its average return since 2009.» Hedge fund of funds are not designed to deliver outsized gains. Rather, they can offer diversification and seek to provide stable returns with low correlations to broad markets. What it may mean for investors» The combination of lower fees and better performance from a hedge fund of funds underlying hedge funds has resulted in an improvement in fund of funds net returns compared to the past few years. We expect this trend to continue.» At this point in the cycle, we believe that mid-single-digit returns and low-to-negative correlation versus global fixed income investments can be quite compelling. Better Environment for Hedge Fund of Funds Despite reports of their untimely demise, Hedge fund of funds ( FoFs ) are slowly, but surely, emerging from a difficult stretch as a deficiency in alpha 1 from underlying hedge funds, coupled with an added layer of fees, had stymied net returns. This, in turn, led to redemptions, industry consolidation, and even an occasional return of capital and firm closure. Yet, the twin tailwinds of higher growth and rising interest rates are improving returns from active management. The HFRI Fund Weighted Composite Index has generated a 12-month return that exceeded 8 percent, more than twice its average since January 2009. 1 Indeed, better returns from underlying managers can translate to better returns for Hedge FoFs. The current 12-month return for the HFRI Fund of Fund Composite Index is 5.6 percent, more than three times its average since January 2009. 2 (It is important to note that an index is unmanaged and not available for direct investment.) Though we always are cognizant of the fluidity of global markets, we do see a more stable environment for active management as central banks become less accommodative and interest rates rise. In other words, we believe that there may be some durability to the stronger performance trends we recently have seen and a compelling opportunity for investors to reconsider Hedge FoFs for their overall portfolios. Remember the Objective of Fund of Funds Hedge FoFs are designed to provide stable, but not necessarily outsized, returns. Because Hedge FoFs normally allocate to dozens of underlying hedge funds, each with different strategies and exposures, one can think of a Hedge FoF as offering global asset allocation in an actively managed structure. In fact, as 1 Source: HFR, June 2017. Past performance is no guarantee of future results. 2 Source: HFR, June 2017. Past performance is no guarantee of future results. 2017 Wells Fargo Investment Institute. All rights reserved. Page 1 of 5
Chart 1 illustrates, Hedge FoF returns generally exhibit much of the same cyclicality as a blended portfolio of global equities and global fixed income, but with less volatility. 3 Chart 1. Hedge FoF Returns Have Largely Tracked Those of a Global Portfolio But with Less Volatility 20% 15% Rolling 36-Month Annualized Returns 10% 5% 0% -5% -10% -15% Dec-92 Dec-96 Dec-00 Dec-04 Dec-08 Dec-12 Dec-16 60/40 Global Portoflio 3YR Annualized Return HFRI FoF Index 3YR Annualized Return Source: HFR, Bloomberg, Wells Fargo Investment Institute, June 2017. Chart is for illustrative purposes only and shows that Hedge FoFs as represented by the HFRI Fund of Funds Composite Index have had lower historical volatility than that of a global portfolio composed of equities and fixed income investments. The 60/40 portfolio is composed of 60% global equities represented by the MSCI World Index and 40% global fixed income represented by the Bloomberg Barclays Global Aggregate Bond Index. Performance results for the 60/40 Portfolio are hypothetical and do not represent actual trading. The indices reflect the historical performance of the represented assets and assume the reinvestment of dividends and other distributions, if applicable. Index returns reflect general market results, do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses or taxes applicable to an actual investment. Unlike most asset class indices, HFR Index returns reflect fees and expenses. An index is unmanaged and not available for direct investment. Hypothetical and past performance does not guarantee future results. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. There is no direct correlation between an index and the anticipated performance of any fund. Please see the end of the report for the risks associated with the representative asset classes and for definitions of the indices. While Hedge FoFs are sensitive to global equity markets, they historically have low-to-negative correlation with global fixed-income investments (as seen in Chart 2). This historical relationship aligns nicely with Wells Fargo Investment Institute s (WFII) current tactical asset-allocation view. WFII currently is underweight developed market (ex-u.s.) fixed income. We believe that having a lower correlation to global fixed income is an important consideration for investors, especially at a time when central bankers appear poised to raise rates as global economic growth improves. 3 The 60/40 blended hypothetical portfolio of global equities and global fixed income securities had a standard deviation of 2.8 percent compared to 1.69 percent for the HFRI Fund of Fund Composite Index as of December 31, 2016. Standard deviation is a risk calculation of the dispersion of individual returns around the average return. 2017 Wells Fargo Investment Institute. All rights reserved. Page 2 of 5
Chart 2. Hedge FoFs Historically Have Low-to-Negative Correlation with Global Fixed Income Rolling 36-Month Correlation 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Jan-93 Jan-97 Jan-01 Jan-05 Jan-09 Jan-13 Jan-17 36M Correlation Between HFRI FoF Index and Global Fixed Income Average Source: HFR, Bloomberg, Wells Fargo Investment Institute, June 2017. Chart shows the rolling 36-month correlation of the HFRI Fund of Fund Composite Index to the Bloomberg Barclays Global Aggregate Bond Index. The average line represents the average rolling 36-month correlation from January 1990 through May 2017. January 1990 is the first month available for HFRI Fund of Fund Composite Index data. Correlation represents past performance. Past performance is no guarantee of future results. There is no direct correlation between an index and the anticipated performance of any fund. An index is unmanaged and not available for direct investment. There is no guarantee that future correlations between the indices will remain the same. Are Mid-Single-Digit Returns Compelling? We believe a Hedge FoF portfolio with a low-to-negative correlation to global fixed income that has the potential to return mid-single-digit returns to be a compelling opportunity. Going back over 27 years and multiple market cycles, Hedge FoFs, as represented by the HFRI Fund of Funds Composite Index have had an average 12-month return of 6.7 percent, whereas individual hedge funds, as represented by HFRI Fund Weighted Composite Index have had a comparable average return of 9.9 percent. 4 A simple, equally weighted combination of hedge fund of funds and hedge funds could generate a potential average annual return of 8.3 percent. 5 The mid-single-digit Hedge FoF returns we expect going forward might not have seemed compelling early in the cycle when equity prices are usually depressed and credit spreads are wide, but that is not where we find ourselves currently. In fact, it now is increasingly difficult to find passive investment opportunities that can deliver the level of expected returns and diversification investors demand for a diversified portfolio of alternative investments. In our view, turning to Hedge FoF at a point when trailing 12-month returns are just beginning to highlight the improving opportunity set is a compelling option and one that we are strongly advocating. Investment Implications In general, the most recent three or five year annualized returns of for Hedge FoFs, and active management have been lower than historical averages. Yet, we believe those investors who are waiting for returns to normalize risk being underallocated at precisely the wrong time. The hedge fund industry is in the throes of change: fees are being compressed while performance is improving. We believe that the combination of the two developments implies better net returns for Hedge FoFs. Furthermore, there 4 Source: HFR, June 2017. Past performance is no guarantee of future results. 5 Source: Wells Fargo Investment Institute, Global Alternative Investments 2017 Wells Fargo Investment Institute. All rights reserved. Page 3 of 5
is, and likely will continue to be, large dispersion among hedge fund returns, which means that manager selection will be a critical driver of alpha generation. We always have believed that Hedge FoF should be considered a core component of a global asset-allocation strategy, and we are keen to remind investors that Hedge FoFs are, in fact, not dead, but rather in the early stages of resurgence. Risks Considerations Alternative investments, such as hedge funds and funds of hedge funds, are not suitable for all investors and are only open to accredited or qualified investors within the meaning of U.S. securities laws. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicles. There is no assurance that any investment strategy pursued by a fund will be successful or that a fund will achieve its intended objective. Investments in these funds entail significant risks, volatility and capital loss including the loss of the entire amount invested. An investment in a fund of funds carries additional risks including asset-based fees and expenses at the fund level and indirect fees, expenses and asset-based compensation of investment funds in which these funds invest. A fund is subject to the risk of being an underlying fund to the extent that a fund of funds invests in the fund. An underlying fund of a fund of funds may experience relatively large redemptions or investments as the fund of funds periodically reallocates or rebalances its assets. These transactions may cause the underlying fund to sell portfolio securities to meet such redemptions, or to invest cash from such investments at times it would not otherwise do so, which may as a result increase transaction costs and adversely affect underlying fund performance. With limited exception, there is no secondary market for hedge funds and none is expected to develop. Hedge funds and funds of hedge funds are not required to provide investors with information about their underlying holdings. As a result, the investor will be unable to monitor the fund s underlying holdings and to discern whether sub-fund investments are consistent with the hedge fund s investment strategy or risk parameters. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Investments in fixed-income securities are subject to market, interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond s price. Credit risk is the risk that an issuer will default on payments of interest and/or principal. High yield fixed income securities (junk bonds) are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Definitions An index is unmanaged and not available for direct investment. HFRI Fund Weighted Composite Index is a global, equal-weighted index of more than 2,000 single-manager funds that report to the HFR database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars and have a minimum of $50 million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include funds of hedge funds. The HFRI Fund of Funds Composite Index is an equal-weighted index of over 500 domestic and offshore fund of funds. All funds report in USD and report Net of All Fees returns on a monthly basis. All funds included in the index must have at least $50 million in assets under management or have been actively trading for at least 12 months. The HFRI Indices are based on information self-reported by hedge fund managers that decide, on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, LLC (HFR). Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways. Unlike most asset class indices, HFR index returns reflect fees and expenses. Index returns do not reflect any fees, expenses or sales charges. Unlike most asset class indices, HFR index returns reflect fees and expenses. Bloomberg Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of 23 developed market countries. 2017 Wells Fargo Investment Institute. All rights reserved. Page 4 of 5
Disclosures Global Investment Strategy (GIS) and Global Alternative Investments are divisions of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company. The information contained in this document has been prepared by Global Alternative Investments (GAI) and the opinions are those of GAI. The views expressed are subject to change and are not intended as investment advice. GAI does not undertake to advise you of any change in its opinion or of the information contained herein. The information or analysis contained in this material has been compiled or arrived at from sources believed to be reliable but GAI does not make any representations as to their accuracy or completeness and does not accept liability for any loss arising from the use thereof. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR 0617-02557 2017 Wells Fargo Investment Institute. All rights reserved. Page 5 of 5