Hedge Fund Strategies: Global Macro vs. Market Neutral

Although hedge funds in general have displayed an uncomfortably high equity beta over the past year, there have been two bright spots – strategies that follow-through on the promise of low market correlation (and therefore, assuming returns are positive, alpha). Global Macro is one such category. Market Neutral is the other.

When you think about it, this is somewhat counter-intuitive. Market neutral funds tend to use more quantitative strategies and trade more often than their buy (/sell) and hold long/short cousins. So you’d think that they rely heavily on market liquidity to get in and out of so many positions so quickly.

You might also think that market neutral funds would rely on funding liquidity to employ leverage. When funding liquidity dries up, one might expect that market neutral funds would therefore suffer.

But it turns out that both of these assumptions may in fact be wrong. A paper by Arjen Siegmann and Denitsa Stefanova of VU University Amsterdam seems to suggest that the more market neutral a fund, the less it is affected by liquidity shocks (market liquidity and funding liquidity).

Rather than relying on managers’ self-identify as “market neutral”, Siegmann and Deitsa divide the universe of equity hedge funds into 5 buckets based on their equity betas. Then they regressed the monthly beta of the funds in these buckets against the TED spread (used as a proxy for funding liquidity) and against a measure of market liquidity called the “ILLIQ” measure (average daily price move over average daily volume).

It turned out that the higher the equity beta of the fund, the stronger the relationship of that fund's beta to both of these liquidity measures. Or put another way, the beta of market neutral funds actually seemed to be less dependent on market and funding liquidity – not more dependent (see charts below constructed with data from the paper).

But the strength of this relationship seemed to vary over time. During the 1994-2003 period, the relationship between beta and liquidity was very strong, while the relationship seems to have been weaker during 2003-2007. Seigmann and Deitsa suggest that this is because of the “abnormal market situation and excess liquidity” during this period.

Still, the returns of high beta small and mid-cap hedge funds displayed a strong relationship with liquidity measures even during the “abnormal” 2003-2007 time period.

The conclusion to be drawn from this, according to Seigmann and Deitsa, is that:

…a puzzle remains where it concerns the fact that the relationship seems to be stronger for indices/portfolios that have the highest beta. That is contrary to what we expect based on our arbitrage argument, and needs further research.

One reason, we’d guess, is the fact that fund betas are non-linear. During liquidity shocks all betas tend to jump as the market tanks. Hence, a positive – and potentially spurious – correlation between fund betas and illiquidity measures. Market neutral funds, by virtue of their small(er) market correlation, simply may not have experienced so extensive a jump in their betas. In other words, shocks to the TED spread and increases in the “ILLIQ” measure may just be concurrent with violent changes (drops) in equity values.

Who knows? But certainly worthy of “further research.”

Comments

[AlphaKing:]

Well market neutral funds should be expected to react less and be less dependant upon liquidity. Market neutral funds are most often hedged more than their global macro counterparts, so a drop in liquidity has less of an effect. Being that market neutral funds are often hedged with more diverse and non- correlated assets they have less basis risk and spread fluctuations, up or down, do not have the same effect on them as global macro funds. Beta for market neutral funds arises from their well-hedged positions and not from broad market movements. When liquidity drops on a broad market basis market mispricing and hedged spreads tend to do better because the mispricing typically will arise from excess and extreme liquidity.

Sep 23 06:41 PM

[contracontr...:]

"You might also think that market neutral funds would rely on funding liquidity to employ leverage. When funding liquidity dries up, one might expect that market neutral funds would therefore suffer."

Really market neutral funds don't require any outside funding from a macro perspective - they are funding the long side from the short side,there is no reason why liquidity shocks should affect their leverage or performance. The risks lie in higher margin requirements and uncorrelated movements among different equities,with the latter very unlikely during a market crash.

"ILLIQ” measure (average daily price move over average daily volume)"

The ILLIQ used in this study isn't a useful measure of market liquidity,because volume depends on many other factors. Realistic market liquidity can't be calculated,it can be only guessed based on how the market reacts to larger buy/sell orders.

Sep 24 12:16 PM

[Josh Stern:]

The years 1998 (LTCM crisis) and 2008 (Lehman, etc. crisis) were different in character than other years from the standpoint of the anti-illiquidity harm done to small cap stocks.

Sep 24 08:51 PM