Do Hedge Funds Really Hedge?

by: Clint Sorenson, CFA, CMT

Summary

Hedge funds do not always provide diversification when needed most.

Strategy diversification can help provide a seat belt to a portfolio without the ridiculous fees.

A simple momentum system would have been a better investment versus the fund of funds index.

Citigroup expects hedge fund assets to double from the current $3 trillion in assets held today. At Emerald Asset Management, we are baffled, downright befuddled at the continued investment in hedge funds despite the risks and the inability to outperform the market over the recent years. Low expected returns from both U.S. fixed income and U.S. equities will make it quite difficult to justify the two percent management fees and twenty percent performance incentives so common in the industry. Since 1990, the HFRI fund of funds composite has failed to outperform the S&P 500 or protect investors. A simpler, more cost efficient solution exists.

The largest hedge fund investors have taken notice of the present disconnects within the market place. In an article published in the Wall Street Journal, Pensions Pull Back From Hedge Funds, Dan Fitzpatrick writes of a massive reduction in hedge fund investments from the major pension plans in the United States. The reasons given were enormous fees and lack luster returns. We expect the trend to continue. The question is where the assets should be reallocated.

According to a board member of one pension plan mentioned in the article, Warren Buffett recommended allocating the assets to index funds. We support the notion of reducing the costs associated with traditional hedge fund investing, but we question whether buying and holding an index fund is a better strategy given the current valuations. Buying and holding an index fund would be ideal when valuations in equities were in the bottom quartile of their historical range. Valuations stand in the top decile (overvalued) for the S&P 500. Under the overvalued circumstances, our recommendation is to use index funds, but through a simple strategy to provide diversification when needed most.

We have arrived at several reasons why people invest in hedge funds. The strongest reason investors buy hedge funds is to protect them from market declines. Hedge funds seem attractive as the very name indicates that they "hedge" the downside risk (or some of it anyway). Modern Portfolio Theory disciples governing many of the larger wealth management firms continue to frame hedge funds in this light claiming that they are "non-correlated" with equities and bonds, providing risk reducing benefits to portfolio composition.

Correlation is simply a measure to determine how assets move in relation to one another. +1 is a perfect positive correlation meaning the assets move together. 0 implies the assets do not move together and have unrelated activity. -1 is perfect negative correlation suggesting that assets move opposite from one another. Reducing correlation lowers the portfolio calculation of risk (as measured by volatility) meaning that if you combine several different assets with low correlations, the risk of the portfolio falls. The idea has been "sold" to investors that hedge funds have low correlations to stocks, but the data suggests otherwise.

Unfortunately for hedge fund investors, the "low correlation" rhetoric is more than likely a historical phenomenon. The correlation between the fund of fund composite and the S&P 500 from 1990 through 2012 was 0.57, indicating a moderately strong positive correlation. . Even worse is the fact that from 2007-2009 the correlation between hedge fund composite and the S&P 500 increased dramatically. In 2008 the HFRI fund of fund composite declined right along with the S&P 500 finishing the year down more than -20%. In other words, when hedge funds are supposed to "hedge" they actually acted to increase the risk of the overall portfolio. Furthermore, the hedge fund composite failed to participate in the recovery since the March 2009 bottom in stock prices, trailing the S&P 500 significantly over the past four years.

We believe investors can use momentum strategies to protect traditional stock and bond portfolios. They can provide diversification without paying 2 and 20 fees and suffering the risks associated with leverage and illiquidity. Below we have provided a simple rules-based system to use as an example. The rules are as follows:

  • Equally weight the historical performance for the past 1, 3, 6, and 12 months
  • Rank the S&P 500 and the U.S. Corporate Bond index based on the performance
  • Pick the strongest index based on the ranking
  • Run the ranking system each month

Here are the year by year results and correlations for the momentum strategy vs. the S&P 500 (SP500) and HFRI fund of funds Composite from 1990-2012:

SP500

FOF

MOMO

1990

-3.06%

17.53%

-3.80%

1991

30.23%

14.50%

12.78%

1992

7.49%

12.33%

6.02%

1993

9.97%

26.32%

2.84%

1994

1.33%

-2.56%

1.32%

1995

37.20%

11.10%

37.58%

1996

22.68%

14.39%

22.96%

1997

33.10%

16.20%

33.36%

1998

28.34%

-4.23%

14.39%

1999

20.89%

26.47%

21.04%

2000

-9.03%

4.07%

-0.53%

2001

-11.85%

2.80%

10.73%

2002

-21.97%

1.02%

2.03%

2003

28.36%

11.61%

19.65%

2004

10.74%

6.86%

5.27%

2005

4.83%

7.49%

-1.16%

2006

15.61%

10.39%

15.80%

2007

5.48%

10.25%

6.70%

2008

-36.55%

-21.37%

1.80%

2009

25.94%

11.47%

21.21%

2010

14.82%

5.70%

16.72%

2011

2.10%

-5.72%

6.86%

2012

15.89%

4.79%

5.51%

The important information to gather from the historical hypothetical results is the performance of the momentum strategy during the years when the market declines. The ability to rotate away from the S&P 500 when the price of the index deteriorates allows for a better performance when trouble is present. The momentum system also keeps pace in the positive markets, participating in the up trends when the S&P 500 is favored. In other words, the simple momentum system acts as a risk reducer during the down markets without sacrificing the upside.

Hypothetical Results

Source: Clint Sorenson, CFA, CMT.

The effects on the bottom line are indicated in the chart. A $100,000 investment in the S&P 500 from 1990 through 2012 would have resulted in an ending value of $648,790.90. The momentum system, largely through the risk reduction effects, would have resulted in an ending value of over $1,050,886.94. Since we are talking about hedge funds here, the chart also displays the results against the HFRI Fund of Fund composite. The fund of funds composite would have grown $100,000 to $513,672.90, failing to keep pace with the stock market average. The flexibility and the protection against prolonged declines reward the momentum strategy with superior results.

As we have outlined above, momentum has historically worked to participate in up markets and protect against deep market declines. While we cannot predict the future trajectory of prices, we know that markets will fluctuate and investors can design portfolios to potentially take advantage of market volatility. Hopefully, strategy diversification can be used to reduce investors' dependency on expensive hedge funds to protect their portfolios.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program.