In today’s environment of low returns and interest rate uncertainty, hedge funds may in fact be the safest bet, according to GMO’s Ben Inker.
“The characteristics that made hedge funds disappoint may well prove a blessing if discount rates start to rise.”In the firm’s latest quarterly letter, the co-head of asset allocation argued in favor of investing in alternatives—which Inker defined as short-duration risk assets such as hedge funds and “hedge-fund-like” strategies.
“These assets…are generally out of favor today given their disappointing performance since the financial crisis,” he wrote. “But the characteristics that made them disappoint may well prove a blessing if discount rates start to rise.”
Discount rates have fallen since the financial crisis as central banks cut interest rates. This in turn benefitted long-duration assets such stocks, bonds, real estate, and private equity, while hurting short-duration assets like hedge funds.
However, while long-duration assets have done well over the past six or seven years, Inker argued that the recent high returns are not sustainable.
“The trouble with returns that come from falling discount rates is that they represent an increase in the present value of an asset without any increase to the cash flows to the asset class,” he explained. “The present value of the assets has risen but the future value of the asset has not.”
High US equity valuations “guarantees that the future returns… from here will be lower than they would have been otherwise,” Inker said. “The same is true for all of the long-duration assets whose discount rates have fallen over the period.”
How much the new low-return environment hurts portfolios will depend on whether the shift is temporary or permanent, Inker argued.
“The charm of alternatives is that we believe they should perform similarly in either the temporary or permanent shift scenario, and there are almost no other assets with expected returns above cash for which that is the case,” he wrote.
While alternatives are “more complicated to manage,” have higher fees, and “require more oversight,” they will be “well worth the extra effort,” Inker said.
“Their generally disappointing performance over recent years, rather than a sign to dump them once and for all, should probably be recognized as a signal of their potential utility in the market environment we face in the coming years,” he concluded. “A deeper analysis of what led returns to be disappointing for the asset classes that have lagged may help investors avoid the error of abandoning decent assets just when their time may be about to come.”
Related: Winners and Losers in Alternatives & Hedge Fund Flows Collapse in 2015