Hedge Funds: Being Right or Making Money?

by: Richard Kang

As mentioned in my previous (and first) entry, I actually started in the industry at a highly specialized hedge fund (separate managed futures and long-short equity mandates) although we never called ourselves a hedge fund. Now I am more focused on traditional long-only, no leverage, broad global asset allocation mandates.

Weird, I know. Everyone else is dumping their mutual fund manager job to start up a hedge fund. Can’t blame them. Sure there’s the money. That’s a reward for being smart, good, lucky or some combination of this and more. However, the truth is that what any type-A personality in this industry wants is independence. What is a hedge fund but a mutual fund with lesser constraints?

Ask any manager what is more important: Being right or making money? I’m pretty sure they’ll say making money. But to make money, you better be right. As a mutual fund manager, you can be right but still perform poorly. In sharp down markets, without the ability to tactically allocate to cash or even short, it’s tough to protect the investor. Rather, it’s all about relative performance in that world, thus the argument that most mutual funds are “closet indexers”. For most readers, everything thus far is nothing new.

What concerns me is that we’ve just seen a very interesting month in May. Comments have been made that it’s the worst month for the S&P 500 in 22 years. To me, the price action of the S&P 500 is nothing like what’s happened earlier in Iceland, New Zealand and markets in the Gulf region. Can we expect more? Possibly, but my concern in particular is oriented towards the performance of active managers, specifically hedge funds. Big down returns in index funds especially for specific areas like emerging markets and commodities are fine. Hey, if you didn’t know these were volatile asset classes or that they had a nice long and fairly stable run up that past few years, welcome to class! But hedge funds should have made a killing this month. After at least two years of unspectacular returns (blame low VIX, low interest rates or whatever else you want) they must have been waiting for a month like this.

However, the word is out that hedge funds in general did not have a good month. I’ll wait to see what the various hedge fund index providers send out later in June for the May numbers, but this would be a great surprise to hedge fund investors. Or should it be? Hedge funds had very decent returns in the first quarter of 2006. VIX was still relatively low and there weren’t any big market events tossing things around. Basically, things were quite boring with decent broad market index returns.

Can we simply conclude that many hedge funds had substantial long positions in commodities, equities and other broad asset classes? That would be too simplistic an answer so I’ll ask it differently. After years of relatively poor returns, have many (or most) hedge funds exposed themselves to broad beta exposure due to the relative scarcity of alpha during the market run up from early 2003 to early 2006? The answer is yes.

Don’t get me wrong. I’m not anti hedge fund. But if hedge funds and “fund of funds” market themselves as “performers in good and bad markets” that implies market neutrality or specifically beta neutrality. There has been significant discussion, especially in the institutional world where costs for beta exposure matter, that hedge funds in general have had higher than expected beta exposures, and specifically to the S&P 500.

So, mutual fund managers said that they manage their funds well to outperform their target benchmark index but have in aggregate been more like index trackers. The question to ask is: Are hedge funds falling into the same trap?

My answer is no. I think that they’re doing what they have to do. Being right or making money? Well, I think they’ve realized that 2003-2006 was basically a desert for returns. Their quest for an oasis has led them to beta exposure. That’s part of being opportunistic. If their strategy (whatever it is whether some form of arbitrage or directional trading) has not worked as in the past due to the current market environment, what choice did they have? Again, they say that their job is to be “performers in good and bad markets” not just “performers in bad markets”.

The only question now is whether their beta or market exposures are so high that they their returns are highly correlated with market returns, especially on the down side. If this correction continues with hedge funds returns moving lock-step downwards, then there will have to be some serious rethinking of their value added by investors as well as some reflection by the hedge funds and “fund of funds” of their own philosophies and processes.