Alternative Investment Management Association
In terms of performance and/or redemptions, turmoil in the global financial markets has led to media reports painting hedge funds in a negative light. Such reports tend to ignore the fact that there are two sides to the hedge fund performance coin – absolute return and conservation of capital. In any period of turmoil, some losses may be unavoidable as managers close current positions (be they in response to margin calls or stop-loss triggers) and reallocate funds to safer asset classes. An objective look at hedge fund performance has to include a comparison against more conventional asset managers. To that end, this write-up examines the recent performance of hedge funds against that of mutual funds, and other long-bias products such as 130/30 funds. The rationale for the comparison is to uncover the effect of varying degrees of short exposure on fund performance. The following table shows the performance ranking of these fund types against the S&P 500:
Table 1: Performance Ranking
|May-08||Long/Short Equities Funds||130/30 Funds||Mutual Funds||S&P 500|
|2008 YTD||Long/Short Equities Funds||130/30 Funds||Mutual Funds||S&P 500|
|1YR||Long/Short Equities Funds||130/30 Funds||Mutual Funds||S&P 500|
|3YR||Long/Short Equities Funds||Mutual Funds||130/30 Funds||S&P 500|
|5YR||Long/Short Equities Funds||Mutual Funds||S&P 500|
Source: Eurekahedge, The Wall Street Journal, Yahoo Finance.
1 All figures are the average returns in each fund category over the respective time period.
2 No performance data is available for 130/30 funds for the 5 year period.
3 Figures in the 3 year and 5 year fields are annualised.
Despite the series of tumultuous market events in recent months, it is evident from table 1 that long/short equities managers have showed resilience in recent months, outperforming the S&P 500 by over 2 percent in May 2008 and by over 4 percent for the 2008 year to date (YTD). Hedge funds also made solid gains across the board over the past 1, 3 and 5 year periods (up to and including May 2008). Besides, 130/30 funds, which employ a different proportion of exposures in investing their funds (130 percent longs and 30 percent shorts), were making modest gains over the same period of time but reported negative figures in 2008 YTD (-3.3 percent) and for the 1 year period (-2.3 percent). In the 3 year period, the funds performed less favourably (5.8 percent) compared to those investing in long/shorts and long-only investments. In contrast, mutual funds posted the lowest average returns among the three fund types, with relatively low returns throughout the time periods considered, except for a climb (12.9 percent) in the 3 year period.
The pattern of performance in mutual funds is broadly reflected in that of the benchmark index, as these funds benefited from up-trending equity markets, for the better part of 2006 and 2007. Hence the superior annualised returns among mutual funds for the 3 year and 5 year periods. In more recent months, the S&P 500 was in negative territory, with a sharp drop of returns (-8.5 percent for the past 12 months and –4.6 percent for 2008 YTD).
Global Market Overview
To put the figures from Table 1 in perspective, let us begin with a round-up of market events that have had an effect on fund performance in the months leading up to May 2008. Following several years of steadily rising markets and low volatility across the board, weakness in the US housing and sub-prime markets lowered risk appetites and led to sharp sell offs in equities and high yielding currencies early in the third quarter, 2007. This gave way to concerns over liquidity, leverage and contagion, raising borrowing costs, widening credit spreads and heightening market volatility. The markets had a respite during Sep/Oct 2007 owing to pro-active measures against risk aversion and dwindling liquidity, from the Federal Reserve and other major central banks. Concerns over weakness in the credit markets re-emerged towards the year’s close, as it became apparent that the losses suffered by some of the large global financial firms were far greater than expected.
For the year to May, global equities have seen mixed performance. January and March showed setbacks whilst February, April and May saw some rebounds from previous lows. The markets had an uncertain start to the year in 2008, owing to counteracting inflationary and recessionary forces at play. Market volatility persisted during 2008 year to May, with aggressive Fed intervention and record high crude oil and precious metal prices lending some support. As energy and food prices continue to soar, together with upward pressure on interest rates and a weakening $US, concerns over inflation have reemerged among market participants.
These market movements provide the basis for the comparative performance analysis that follows. For the purpose of this study, data has been used from the WSJ’s online Markets Data Centre and the Eurekahedge index. The idea is to contrast the performance of long-only investments against those with an element of short exposure. To this end, a comparison is made of returns over the last 5 years across this spectrum of investment mandates (see Figure 1, where the S&P 500 index is used as a proxy for mutual fund returns). Long/short equity managers combine long investments with short sales in order to reduce portfolio risk. A 130/30 fund is also considered to employ an equity long/short strategy. However, its structure is made up of 130 percent exposure to longs and 30 percent to shorts. Each investment style, (mutual funds, long/shorts and 130/30s) carries a different degree of exposure to the changing markets.
Figure 1: Index Benchmark
1 The Eurekahedge Long/Short Equities Hedge Fund Index is made up of all index constituents funds (447) that report to Eurekahedge.
2 The Eurekahedge Enhanced Equity (130/30) Hedge Fund Index is made up of funds (23) that report their returns to Eurekahedge.
3 The S&P 500 historical prices are obtained from Yahoo Finance, from Dec-02 to May-08.
From Oct 2007 to Mar 2008, the S&P 500 fell 14.6 percent with significant divergence from hedge fund indices during the year to May 2008. Returns from the market index have been uncertain since the US housing crisis broke last June, with subsequent dips in any period of turmoil. However, there is some evidence that hedge funds are able to provide downside protection during negative periods.
To reiterate this point, let us examine the figures in Table 1, comparing average returns for each fund type over the periods of 1 year, 3 years and 5 years to May 2008 depicted in Figure 2 below. As can be seen, hedge funds perform better in conditions of rising volatility; long/short equities funds outperformed mutual funds by over 3 percent and 4 percent during the 3 and 5 year periods and by over 0.3 percent in May 2008 alone, (a month that saw rallying equities and marked reversals in the bond and currency markets). The funds were down, on average, 0.6 percent for the year to May 2008 but remaining strong, whilst 130/30 funds and mutual funds were severely affected, each with losses of -3.3 percent and -3.5 percent. For a further case in point, major equity markets staged a strong rally in April and May 2008, as managers registered solid gains across the board. Also, taking short positions in consumer durables helped managers to offset some of their losses in the same period. Likewise, during the twelve months to May 2008, only long/short equities managers turned in gains to the tune of 5.6 percent, while 130/30 funds (-2.3 percent) and mutual funds (-3.1 percent) were in negative territories. Overall, the result is revealing, with long/short equities funds showing significant outperformance in the long run, and safeguarding capital in the more turbulent short run: Conservation of capital, being one of the primary goals of hedge funds.
The analysis also supports the claim of absolute return, the other primary goal of hedge funds. Assuming an annual risk-free rate of 4 percent and the S&P 500 as the efficient frontier, both 130/30 funds and mutual funds posted negative (Jensen’s) alpha figures over the twelve months to May 2008 (-3.2 percent and -7.1 percent respectively) against the S&P Index, while hedge funds generated an alpha of 2.7 percent during the same period.
Figure 2: Comparison of Returns
Sources: Eurekahedge, The Wall Street Journal
1 Performance data for Long/Short Equities Funds is based on approximately 54 percent of the funds reporting their May 2008 returns as of 13 June 2008.
2 Performance data for Mutual Funds is derived from a total of 2,286 ‘Global Stock’ funds
3 Performance data for 130/30 Funds is based on 32.39 percent of the funds reporting their May 2008 returns as of 13 June 2008.
Market volatility remains at elevated levels, driven by continued economic headwinds and aftershocks of the sub-prime quake. Also, inflation fears are beginning to pick up, deepening anxieties that banks and securities firms will suffer even more hits from the credit crisis. The jump in the unemployment rate last month, coupled with accelerating oil prices has added upside risks to inflation. The Fed have taken aggressive steps to counter the existing market problems, initially in the form of rate cuts, then shifting focus to inflationary pressures. Such moves have been interpreted by some market participants to mean that the end of the financial crisis is nigh, while many others insist that it is only the first phase of turbulence.
Insofar as hedge funds employ flexible investment strategies with an aim of consistent positive and risk-adjusted returns, outlook for fund performance in the coming months remains positive. Despite the broad market movements, hedge fund managers could still make decent gains by flexibly adjusting their positions, diversifying in terms of investment strategies and regional mandates, de-correlating from the market and, therefore, profiting from a changing economy. More specifically, with crude oil and precious metals around their record highs, the dollar still weak against major currencies and equity valuations relatively low across the board, managers could profit from both the long and short side in the coming months. Furthermore, the persistent volatility could also translate into some gains for arbitrage and relative value plays.Back to Listing