Since the financial crisis, alpha — the ability to generate returns above a market benchmark — has been relatively hard to come by. Investors who chose to allocate capital to passive strategies, potentially splitting their investments in a 60/40 ratio between stocks and bonds have generally seen positive results. This kind of strategy, which helps reduce management fees, has generally outperformed the hedge fund industry by a not insignificant amount over the past few years, as bond yields have ratcheted ever-tighter, and the equity markets have hit record highs.
It may be, though, that we've come to an inflection point. There's a built-in human assumption to expect the world to continue operating as it has always done. It's worth stopping for a moment to think about the experience of the traders and investment managers whose combined decisions ultimately guide the markets. Despite the Warren Buffetts of this world, the finance industry tends to be staffed by people in their 20s and 30s. Even those at a senior level are generally, like me, veterans only of two decades or so, having joined the market post-1994. Even we older participants have only experienced a series of deflationary shocks met with lower rates and some form of quantitative easing — a world of soluble financial problems. On top of this, many of the analysts working across the investment industry today are often from the post-2008 vintage, meaning they have only ever witnessed rallying markets (at least in the U.S.). When paradigms endure for a whole generation of market participants, it can take a significant leap of the imagination to imagine them ending.
So what do we think is going to change, and why? Let's think first about those 60/40 portfolios. The theory behind this kind of portfolio construction is that diversification can help bring more predictable risk-adjusted returns, so that the fixed-income component outperforms when equities underperform and vice versa. The worst thing imaginable for investors in this kind of passive strategy is positive correlation between the two asset classes, whereby both bonds and stocks move lower in tandem. And yet, as the chart below illustrates, over the past century or so, bonds and stocks have been positively correlated more often than not. It's only this century that we have seen negative correlation become the rule rather than the exception.
My colleague, Ben Funnell, has looked at this relationship in detail, tracing the correlation between the asset classes back into the 18th century. From this enormous amount of data, he has designed a model showing the relationship between stocks, bonds and inflation. He has called it "Fire and Ice," after a poem by Robert Frost.
The theoretical model above is hopefully fairly self-evident, but in brief it states that inflation moves in cycles, from the fire of inflation to the ice of deflation. These moves can take many years, even decades, to play out, but the crucial thing to note is that it appears we are currently in the bottom-right corner of the matrix.
We have endured a period of deflation that has been largely counteracted by central bank activity, and are now seeing inflation picking back up. Worryingly for passive investors, this means we could be heading toward the worst-case scenario for them — a deeply inflationary environment in which both stocks and bonds suffer.
Valuations in equities already are looking stretched, in our view. Analysis from Goldman Sachs suggests both U.S. and European stocks are trading at significant highs relative to history. For example, as at June this year, the S&P 500 was trading at the 90th percentile in terms of forward price-earnings ratio over a 40-year period, and the 97th percentile in terms of P/E to growth. Europe is not much cheaper, where the median stock in the Eurostoxx commands a price in the 92nd percentile vs. history. While some of this might be down to global economic growth, central bank policy also plays a part — so investors will be watching closely as the Fed continues its rate hiking cycle, and the European Central Bank moves closer to talk of tapering. Inflation remains low, but if we start to see signs of a rise over the coming months, the response of central banks will be key in our view. Our sense is that no one is prepared for the top-right quadrant of Ben's matrix.
Crucially, though, if we do move toward the "fire" scenario, equities could only be part of the problem for passive investors. The real stress might come in bonds, which have had such a long run of (arguably artificial) outperformance. In a rising interest rate environment with potentially no more support from central banks, bond prices could be hit hard. Added to this are potentially pent-up credit problems that might have been pushed into the long grass by accommodative policy and forgiving (or merely yield-hungry) investors, and you could have the perfect storm of negative price action and a potential raft of defaults. And this potential fixed-income scenario might have to be addressed by a generation of money managers, many of whom have never faced a bond bear market.
All this is, of course, potentially good news for the hedge fund industry. The argument for investing in hedge funds has always been the excess return potential that they offer over the course of a full cycle, independent of market conditions. It's true that many passive strategies have been on an impressive run recently, but it's not in markets like those of the past few years that hedge funds have historically done well. If the "Fire and Ice" model is correct, the financial markets may have a difficult time ahead of them. And it is here we feel we may see the true diversification benefit offered by hedge fund investments, and the potential for uncorrelated alpha generation. The hedge fund industry will be tested by fire, and I believe it will prove its worth.
Pierre-Henri Flamand is chief investment officer at Man GLG based in London. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.