Buy-and-Hold As Good As Hedge Funds?

Having examined how the timing model holds up against the Harvard and Yale endowments, how would it compare to the other brightest minds (and highest paid) in the room? In an earlier post, I examined the structure and characteristics of hedge fund databases and indices. Although the study is dated, here is a link that reveals that only 3% of hedge funds are represented in the 5 major databases.

Below, I am going to examine how a simple buy and hold asset allocation(labeled AA) and our timing model compare to the hedge fund indices. With the understanding that the hedge fund indices returns will likely be overstated, I present the year-by-year results of the timing strategy vs. the HFRI and HFR FOF indices (HFR is the longest time series available). For an apples-to-apples comparison, we have omitted any management fees to invest in either the hedge fund indices (index provider fees) or the timing models (ETF, mutual fund fees). Both should be on the order of 20 to 100 basis points.

Interestingly enough, even without making any adjustments for survivorship biases, the buy-and-hold asset allocation is nearly identical to the FOF Index across all measures except for correlation to the S&P 500 (SPY). The timing model beats both buy-and-hold and the FOF Index with a higher CAGR, and lower volatility, drawdown, and worst year.

The 2X levered model likewise compares very favorably with the HFR Index, with slightly higher CAGR, higher volatility, and lower drawdown. Even more intriguing is that all of the strategies come incredibly close to the same number of positive months

The chart below depicts the equity curves of the two timing models, the two hedge fund indices, and the S&P 500.

The timing models yearly correlations of returns are in the .50-.60 range, while the FOF index is .34, and the HFRI is .63. This makes intuitive sense because the timing model includes the S&P 500 as a 25% component of the portfolio. Removing the S&P 500 and equal-weighting the four remaining indices results in near identical risk and return figures with a drop in correlation to .26. The table below presents this evidence.

The CSFB/Tremont Hedge Fund Index is asset-weighted, and all funds must have a minimum of $50 million in assets under management, a minimum one-year track record, and current audited financial statements. There are approximately 900 funds in the index, no FOFs are included, and performance is net of all fees.

The Greenwich-Van Global Hedge Fund Index includes approximately 2000 funds that must have a minimum one-year audited track record, open to new investment, a minimum of $20 in assets, and a US dollar share class must be available.

A simple buy-and-hold of diverse asset classes would have produced near identical results as the CSFB/Tremont hedge fund index, although lagging the Van Index in CAGR. The results of the timing model were superior in every measure of risk and return versus the CSFB-TASS Index. The timing model outperformed the Van Index on a risk-adjusted but not on an absolute basis.

Similar performance without all the headaches of wondering if your manager is boarding a plane to Costa Rica with your cash. . .Not to mention lockups, liquidity risk management, or transparency problems. . .

Example ETFs of asset classes mentioned in the article are:

Comments

[Maverick Bian:]

It depends on how you define timing here. Statistically earnings from timing the markets, in our words, high frequency trading or very short-term trading with a high portfolio turnover, only represent 7% across the board, per one research source, which means for another 93% as a fund manager you need to take directional bets, more or less. Even for market neutral fund, they take some degree of directional bets on specific positions while on portfolio aggregate level they keep exposure to one designated benchmark almost to zero. Yet, if you were to test them with other benchmarks/risk factors, you might be surprised they in fact not market neutral in a strict sense, especially during a specific time window. Based on market efficiency theory, if you didn't take any risk, you're not supposes to have a return, let alone excess return(no-free lunch theory): that's why equity market neutral/arbitrage hedge funds across the board have been ranked almost on the bottom, compared to other HFRI indices during the past 3 to 5 years. However, they typically use a very large leverage, which increase other risk on other fronts and LTCM is a good example in this regard.

I looked into almost all timing funds including high-frequency, programming trading, volatility arbitrage, CTA, and the like, and I found most of PMs are former traders or programmers, options traders, futures, stock traders, currency traders, or trading oriented. They like to trade, in their words, “Since most of time orgasm only lasts for a couple of days, why should I hold it for months, and even years?” And most of time, they're running a very highly concentrated portfolio if they target an unbeatable return, except for program-trading and market-neutral funds. I have a friend who is totally a new horn on US stock markets: last year jumped in and have earned more than 1000% so far, compared to overall market return at 16% around. But the risk he has undertook is huge. Personally he may be a good trader, but he's far, far away from a good portfolio manager.

Typically for timing funds because they need to capture enough themes/catalysts to grow their portfolio fast, so capacity becomes a big issue for most funds in this category. And statistically more than 90% of traders cannot live longer than 5 years unless they can evolve themselves into a well-disciplined risk manager-esque. If Brian Hunter can disciple himself, Amaranth remains a shining star, I guess. If markets are so shallow and you put in so many orders/contracts, you're actually take on a huge risk of be manipulated by others as well as by counterparties. And if JPM could have released its billion-dollar collateral on Friday, and Amaranth would still have been alive; it’s huge sales pressure on Monday that declared the demise of Amaranth, due to the street “rumors”.

Is buy-and-hold a good strategy? I'm not sure, but if you're running a book with billions of dollars of buying power, you may have no choice but wait for big events like earning surprises or something, because every move you make will have a great effect on the underlying price. Based on my thorough research in the entire hedge fund world, I found most fantastic returns are most likely associated with funds during its every early start-up stage with AUM much less than $50mm. So, if you're not a large investor, a small boutique may give you a surprise from time to time. And if you were to move your comparison window starting from 1990 to 2001, you’ll get the totally different views on the hedge fund industry, I’m sure.

Still, statistical rules will not apply to a few individual case, so I would suggest you not care too much about the whole industry, only focus on how to improve your own portfolios, because based on some preliminary outcomes from Maverick 500 Hedge Funds Project, there still is enough room to grow your portfolios if you can pick those talented managers. Yet, if you're a pension fund manager like Calpers, I would suggest you go for an FoHFs since you have a specific mandate and need to feed myriads of retirees on a monthly basis while not dipping into the fund’s principal. Only pursing a high return on a few single-manager names is not a good way to go.

Just my 2 cents!

Maverick500

2007 Mar 01 09:31 AM