Investors buy hedge funds for two reasons – performance and diversification from traditional asset classes. Usually, you can achieve the desired performance through more traditional asset classes as well, but if you share our view that we are currently in a p/e bear market3, you would probably also have to agree that one may have to look towards alternative asset classes in order to generate satisfactory long term returns. A p/e bear market does not imply continuously falling equity prices. In prior p/e bear markets, which have lasted 13-14 years on average (to see charts, click here), stock prices have enjoyed good years in between the not so pleasant ones. However, in the last 200 years, we have experienced 7 periods of 8 years or longer, where p/e values have declined significantly, resulting in average stock market returns during those periods which have only just exceeded the level of inflation.
We originally highlighted this to our readers back in June 2004 4 . It is our contention that the spring of 2000 marked the start of a new p/e bear market. In such a market environment, investors cannot rely on the stock market to generate the returns they require. They must seek alternatives.
It is partly the search for higher returns which has caused the explosion in the growth of hedge funds in recent years. However, investors have been disappointed by the performance so far. Many hedge funds have not delivered the absolute returns5 investors were told they were capable of, a point which leads to our first observation:
Not all hedge funds offer absolute returns, in the same way as not all absolute return funds are actually hedge funds.
Let’s illustrate this by looking at a few charts. However, before we do that, let’s point out that the analysis in the following focuses exclusively on equity long/short funds 6 . There are two reasons for this. Firstly, it is by far the single largest segment within the hedge fund universe – about 50% of all hedge fund assets are directly or indirectly invested in long/short strategies. Secondly, equity long/short is often the choice of default for first time buyers of hedge funds.
How do funds compare for volatility and performance?
Chart 3 (see next page) compares long-only global equities (represented by the MSCI World Index – the red dot in the chart) to equity long short funds (the green dot) over the past 2 years. The small grey dots represent all the individual equity long/short funds which make up the equity long/short index.
It wouldn’t be unreasonable to expect equity long/short funds to have underperformed global equities over the past 2 years but, at the same time, you would expect them to be less volatile as well.
As you can see from chart 3, equity long/short funds have indeed underperformed long-only equities but, to add insult to injury, they have
also been more volatile!
In other words, risk-adjusted returns for equity long/short funds have been inferior to those of long-only equities.
How do hedge funds score for diversification?
We mentioned earlier that there are usually two reasons why investors would buy hedge funds –performance and diversification. As illustrated in chart 3, equity long/short funds haven’t really done the job in the past few years as far as performance is concerned. Let’s now take a closer look at the diversification argument.
Chart 4 compares monthly performance numbers for long-only equities and equity long/short funds over the past 2 years. If equity long/short funds do their job properly, you would expect them to preserve investors’ capital during difficult periods.
As you can see from chart 4, in the past 2 years, global equities have suffered 5 months of significantly negative returns – January, March, April and October 2005 and May 2006. In all of these months, equity long/short funds were down as well, raising a suspicion that perhaps equity long/short funds do not deliver the diversification benefits which are expected of them.
In order to test this thesis, we have run a 10-year chart showing the correlation between longonly equities and equity long/short funds. As you can see from chart 5, the correlation has risen significantly over the last decade. Whereas ten years ago, the correlation was hovering around 0.4-0.6, it is now in excess of 0.9!
Based on the above, we can only reach one conclusion. As far as equity long/short funds are concerned, total returns have been disappointing.
Risk-adjusted returns likewise. And the diversification argument does not stand up to closer scrutiny either. In other words, on average, equity long/short funds are not doing the job they are supposed to be doing.
In our last chart, we have analysed how riskadjusted returns have drifted for equity long/short funds over the past five years (in chart 6 below, the smaller dots represent more distant data points whereas the larger dots represent more recent performance). It is clear even to the casual observer that equity longshort funds have experienced a rather dramatic deterioration in absolute performance. At the same time, volatility has dropped substantially.
Are hedge funds managers now more risk-averse?
Partly responsible for the reduction in volatility is unquestionably the fact that global equity markets are less volatile today than they were five years ago. However, we strongly suspect that equity long/short managers are also more risk-averse today than they were half a decade ago. Why is that?
Two reasons: Hedge fund managers are increasingly inclined to protect their business franchise at all cost. More and more managers can now live very comfortably on management fees alone which may impair their appetite for risk.
Secondly, institutional money accounts for a larger and larger share of hedge fund assets under management and, as we all know, institutional investors have a different agenda from the original buyers of hedge fund products (i.e. high net worth individuals). To the CIO of a pension fund, low volatility is often prioritised higher than superior returns so, in some way, hedge fund managers are only responding to what their largest customers expect them to do.
Should we then conclude that one should no longer invest in hedge funds? Absolutely not. However, it is becoming increasingly important to distinguish between directional and nondirectional hedge fund strategies. As we have illustrated above, a large number of equity long/short funds are directional. And why pay someone a 20% performance fee if you can create the same risk/return profile by combining a really good long-only manager with an investment in money market funds?
So, yet again, the answer is to think outside the box. Hedge funds are not one but 20+ different asset classes. Some of these are truly nondirectional, and we believe it is in those corners of the hedge fund universe that investors should look for both returns and diversification. More about this next month.
By Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels, email: njensen@arpllp.com