Topic:

Alternative Investing

Recently I used the CalPERS decision to eliminate their hedge fund program as a good time to review some of AQRs long standing comments on the industry ultimately being sympathetic to CalPERS decision. I included the self-serving caveat that I still believe hedge funds provide exposure to many good strategies that deserve to be in a portfolio, but I argued that they should be more fully hedged, more transparent, and delivered at a lower fee. I included in that entry one mild counter-point partially defending hedge funds. Namely, that some pick on hedge funds using flawed comparisons. The fact that hedge funds on average don’t run at equity betas of either 1.0 or 0.0, but somewhere in between, confuses the dialogue. This entry expands on that one counterpoint as the flawed comparison I cite has gone viral.

It turns out, not surprisingly, that the CalPERS move has indeed inspired many others to also write on hedge funds. Unfortunately, a great deal of them suffer from the flaw I mention above. They focus on performance, sometimes very short-term performance, often, if not usually, confused by the beta issue. Just a few examples include here. here. here. here. here. here. here. here. here. here. here. here. here. and here. To be fair these are written by very smart people, who share many of my own concerns (yes, sadly, thats part of why I think theyre smart!). But, the beta confusion trap shows up again and again. I explicitly addressed this in #7 here all of the above can be considered a case study of this peeve, and the rest of this post is more specific evidence that people must account for this beta issue better.

In this entry, Ill review the evidence using the same hedge fund indices most of these articles use. These indices are generally seen as imperfect with some degree of survivorship bias. This bias may overstate returns, particularly in the earlier days. However, some argue the other way claiming these indices understate returns as many well-known managers are not represented. I would guess the returns are still biased high, but the real message is dont take this analysis too literally as a blanket defense of hedge funds. Instead, take it as a fair counter-point using the exact same data the critics are using.

Below I touch on many of the sound bites currently being quoted as damning to hedge funds, and explain why they generally miss the mark while asking the reader to remember Im generally, and very recently again, a critic calling for various reforms of the hedge fund industry. I think hedge funds, as they stand now, deserve criticism, just the right criticism! Finally, this piece is about the industry as represented by the indices; obviously its not close to applicable to every hedge fund.

First a Regression (Perhaps Emotionally)

For hedge fund data I use the average of the monthly returns of the overall Credit Suisse Hedge Fund Index, and the HFRI Fund Weighted Composite Index. Regressing the overlapping, rolling annual (excess over cash) returns of hedge funds on the similarly constructed annual returns of the S&P 500 from 1994-2014 (ending June) you get:

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The numbers in parentheses are t-statistics adjusted for overlapping observations. Using annual returns limits us to only about 20 independent observations, but results dont vary much over other horizons, and this is a simple way to partially adjust for the lags in reporting found by Asness, Krail, and Liew (2000). This method finds some small, statistically significant positive outperformance (monthly regressions, even adjusting for lags, find somewhat larger outperformance and larger betas but the point is analogous).

So, over the full period, as mentioned above, hedge funds have not been fully hedged to equity market returns, which would be a beta of 0.0. They also have not been close to fully exposed to equity markets, a beta of 1.0. Therein lies the rub. I think if they were fully hedged (0.0) or fully invested (1.0) wed save a lot of confusion.

Just Look at 2013

One accusation the critics make is just look at 2013 when hedge funds, mistakenly often assumed to be very aggressive investments, failed miserably to keep up with the S&P 500. They were up 9.4% versus a whopping 32.4% for the S&P 500. Oh the humiliation. But, lets ask ourselves, seeing as hedge funds arent close to fully invested in stocks, and by definition the part of returns not captured by the regression is uncorrelated to stocks, how shocking is this? Below we plot rolling annual total returns of our hedge fund index against the same for the S&P 500 with 2013 being the red triangle. The graph is very consistent with the regression results shown and discussed above. There is a positive relationship between hedge funds and equity markets, but that relationship is far from one-to-one.

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So, yes, it was a disappointing year (lying below the regression line). Thats not a shock given its a year the critics choose to focus on. But, it was really only mildly disappointing. Just looking at hedge funds versus stocks it seems like a really bad year for them. But, when you adjust (statistically or just with your eyes) for the fact, one well known before 2013, that hedge funds as a group are net long but way less net long than 1.0, you expect them to trail in such a year. I could bore you with standard deviations, but there are obviously plenty of years that lie further from the regression line than 2013. Essentially, most of the 2013 based criticism of hedge funds is driven by a failure to understand that hedge funds are not meant to keep up with the S&P 500 one-for-one, certainly not when it soars. Of course some stars will keep up, either by luck or skill, but as a broad category its never been the case at such a time.

As an aside, to keep it simple Im sticking to U.S. stocks, but hedge funds often run fairly global portfolios, and given the U.S. outperformed most of the world in 2013, this is a somewhat tougher comparison to make for hedge funds that year.

Just Look at 2008

Another data point thrown at hedge funds is about the opposite environment. Not only did they fail to keep up in 2013, but they failed to protect you in 2008. True! But yet again we must ask how surprising this is to one who knows that hedge funds are neither fully hedged nor fully exposed to stocks? Below the green square highlights calendar year 2008 on the same graph from above.

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Again, a disappointment even versus my regression line (remember, again, we are defending periods the critics have already chosen as disappointing, so we start out in the hole!). But, again, a far more mild disappointment (roughly half as surprising). Given how crazy markets were back then, its probably less surprising than that some statistical techniques adjust for different volatility environments but I have kept it simple here. Going the other way, regression betas pre-2008 were a bit lower (about 0.32 vs. the 0.37 I show above for the full period) so on that front maybe its a bit more surprising. Forces go in both directions, but all considered, its a way smaller shock than just looking at the total return while ignoring the beta to equities.

In fact, when one realizes that hedge funds are, and always have been, only partially hedged to equity market returns, neither 2013 nor 2008 would make anyone jump up and say, Wow, hedge funds acted shockingly differently than we expected. Ignoring their positive beta (Just look at 2008), or implicitly acting as if its 1.0 (Just look at 2013), makes for some exciting sound bites but is very misleading. By-the-way, some actually over-praise hedge funds for only losing about 20% in 2008 while equities lost much more such lauding is equally missing the point as the critiques I highlight here just from the other direction.

Just Look at the Last 10 Years, or Versus 60/40, or Any Other Way You Like

Some of the critiques have focused on the more reasonable comparison to the 60/40 portfolio of stocks and bonds. Lets look at that, and at some other statistics on all the portfolios. Stocks are again the total return on the S&P 500 index, and bonds are the U.S. Barclays Aggregate Index.