What August says about market neutral funds: not much
Sep 11th, 2007 | Filed under: CAPM / Alpha TheoryAlpha Male has been getting a lot of media inquiries recently about why market neutral funds lost money last month. It’s almost as if some of the more skeptical members of the press now smell blood in the hedge fund water. They see that there were market gyrations in August and that some market neutral funds were down. Ergo, market neutral funds aren’t that neutral after all.
In fairness, it’s easy for some to reach this erroneous conclusion. Through a grand game of broken telephone involving the industry and the popular press, the impression has been established that market neutral funds must have a low volatility, won’t move in the same direction as the markets, and will act as a hedge against market drawdowns.
But all three assumptions are wrong. Market neutral funds aim simply to have a low market correlation and, like all funds, they aim to produce alpha. That’s it. No automatic promise of low volatility, and certainly no promise that they will act as a hedge against a long position in the market.
By this standard, market neutral funds – even the stinkers - may have performed entirely appropriately in August after all.
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An anonymous reader writes:
I don’t know where Brett Arends got his information, but below is the explanation I gave on what happened to long/short and market neutral funds. It had nothing to do with correlation to the market as I am sure you point out…
Some time near the end of July, Goldman Sachs began to unwind the 5X leverage of its Global Opportunities Fund. This is a long/short hedge fund quantitatively managed, but not market neutral. Estimates indicate this was in the area of a $20billion unwind. Understand that anunwind of this sort involves both buying and selling of equities to reduce long and short exposures. In this fund there was greater long exposure than short so the net transactional pressure was to push the indices down, but not by amounts that were unreasonable by historic market standards.
Inside the indices was a completely different story. The stock effects were that quality stocks were falling and lousy stocks were going up. The up and down effects individually were very different than the index which benefited from the countervailing impact of the stocks going up and the stocks going down. Not only did the short side have to suffer this ignominy, it also experienced a classic short squeeze, which increases borrowing costs dramatically.
Quantitatively managed hedge funds generally lever themselves to attain a desired level of total risk. The past year has seen overall risk levels fall to a secular low with the consequence that funds had scaled up their leverage to secular highs. When the Goldman transactions hit the market, the daily stock volatility spiked tripping the scaling (leveraging) variable. Simultaneously all leveraged, quant hedge funds started selling and buying just like Goldman, wreaking havoc in the market of stocks, but not the stock market. By August 10, it was over.
Who would be hurt most? There are three parts to answering this question. Quantitatively operated funds all base their portfolio selection and construction on similar notions. That is not say that they are exposed to the same stocks, but they do have similar exposures. Long/short and market neutral funds have exposures in two dimensions and both were being assaulted. Finally, higher leveraged funds will have exaggerated long and short exposures making the assault punitive indeed.
All this adds up to say the candidates for being dunned the most are quantitatively managed, highly leveraged, long/short and market neutral funds. Unleveraged versions of these strategies, such as those run by Analytic and PanAgora for institutional clients, fared much better.
The effect on the market was transitory. After this brief, brutal dislocation, mean reversion kicked in and many regained their lost value and the most prescient actually outperformed. Those that did not comprehend what was going on and/or could not releverage as fast as they had deleveraged had substantial losses with the result that many funds could be wound up.
I won’t pretend that I can provide the same insight Alpha Male has, but I have run some numbers on a collection of these long/short and market-neutral funds. The bottom table is likely to be what you’re interested in – http://www.etf-central.com/brief-survey-market-neutral-and-long-short-mutual-funds-173
Very cool. Thanks for doing the “heavy lifting” here Michael. I’d recommend readers of this posting have a look at Michael’s extensive analysis of market neutral mutual funds.
Excellent article and comments: many investors will likely make the erroneous assumption challenged there. Just one quick comment: for funds that usually target mid/high single-digit annualised volatility, Beta may appear low regardless of market link as it scales down correlation by a ratio equal to fund volatility/market volatility. There’s an old (2000) Risk Magazine article on this, as well as a footnote on Cliff Asness’s paper on whether HFs hedge of some time ago.
Giovanni, thanks for the heads up on the Asness footnote. For those readers not familiar with this paper, here’s the link:Â http://papers.ssrn.com/sol3/papers.cfm?abstract_id=252810. See footnote on page seven.
This posting (coincidentally from exactly one year ago yesterday) also addresses this hidden dynamic of beta: http://allaboutalpha.com/blog/2006/09/15/the-cult-of-beta.