Exactly how bad was September for hedge funds?
Oct 22nd, 2008 | Filed under: Performance, Analytics & Metrics, Today's PostThis bad…
The following series of scatter plots are based on data from Hedge Fund Research. As you can see, the urban legend that hedge funds “deliver absolute returns in good times and bad” was clearly never supported by the historical evidence. The following chart stacks the broadest index available, the HFRI Fund-Weighted Composite, against the monthly S&P 500 returns (since January 1990). The black line is the linear regression (the slope of which is the beta of the index vs. the S&P 500) and the red circle is September 2008.
While this index includes around 10,000 funds, a look below the surface at different sectors reveals some interesting trends. For example, about a third of this composite index is made up of the “Equity Hedge” category…
This index performed even worst last month than the broad composite. While September was clearly out of line with historical returns, the lion’s share (around three quarters) of this category is made up of “Fundamental Value” sub-strategy defined as being decidedly long-bias:
“…typically focus(ing) on equities which currently generate high cash flow, but trade at discounted valuation multiples, possibly as a result of limited anticipated growth prospects or generally out of favor conditions.”
To many, so-called “Market Neutral” funds are the prototypical hedge fund. While these funds only comprise a small portion of the constituents in the index, they stayed true to their name for most of their history - until September…
Thankfully, market neutral funds seem to be back to their neutral ways in October. Several weekly indexes are now showing them to be roughly flat so far this month (while other strategies continue to suffer).
The real winner (if you can call it that) was the “Macro” category. Those funds logged a narrow loss for the month, but actually beat what a linear regression suggests they should have delivered.
While September was bad for most categories, nowhere was the draw down as pronounced as in the “Relative Value” group. These funds pursue fixed income and volatility strategies. Multi-strategy funds are also included in here:
September’s data points stick out like a bump on a log. And by mid-month, October was looking equally grim for many of them. So that lonely blue dot may have some company pretty soon. Stay tuned.
Most of the time we quants do these types of regressions, we first subtract an appropriate “risk free” rate of return that explains how a pure T-Bill investment gets a bit of return each month.
For many hedge funds, we could do something clever like subtract the T-Bill AND three times the spread of LIBOR over bills, to account for the typical leverage arrangement.
If you did that, you’d explain why these funds get “steady” returns when the S&P is neither up nor down, and you might make the underlying low-beta return line even more clear-cut (with less noise around the fitted line).
Many hedge funds only look good after fees because of mis-measurement… they inherently offer very little value-add, but merely play with futures to create option-like returns that mask the underlying risks or market exposures.
All of those look like pretty low betas to me. Less than 0.5. They really should be proud. En serio! Low correlation is low correlation, regardless of outliers. Even a TOTALLY uncorrelated return series (which the above aren’t, obviously, at least not totally) would still be expected to have an occasional down month at the same time as the overall markets.
Usually the stringent definition of “absolute return” refers either to (1) lack of a benchmark index, such as using RF+ or some fixed number for the watermark, or (2) pursuit of return without a volatility-adjusted context. (2) is more rare and I’ve only seen it used in that context for managed futures/CTA trading.
The ridiculousness (R.R., you listening?) of thinking “absolute return” means “never a down year” should be left to those who are, sadly, incapable of understanding a more nuanced argument.
Have to agree with Bill on that on. Low correlation doesn’t mean it never rains in hedge fund land.
I think long beta exposure is only part of the picture. The underperformance relative to the S&P500 index for all but the macro strategy is probably due to credit risks of the other strategies. Global macro, particularly when it’s based on futures trading, isn’t levered with credit, and isn’t exposed to counterparty risk. They can essentially be independent of their prime brokers, and thus weren’t hit with sudden rises in transaction costs, or the bankruptcy of their PB.