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Cliff Asness of AQR recently wrote a nine-page article titled “The Hedgie in Winter.” In this article, he argues that “hedge fund returns shouldn’t be compared to 100% long equities” and thus offers “a more proper comparison” for hedge fund returns. I disagree with his thesis. In the following lines, I will build my case to prove that, if we cannot compare all hedge funds to equity indices (say the S&P 500 Index for example), some of them at least should be. Additionally, depending on the investment period used, hedge funds either add some value or truly underperform equity markets. That is to say that one would be better off, performance-wise, buying Exchange-Traded Funds from Vanguard or Blackrock for less than 10 basis points).
First, I must admit that comparing the returns from hedge funds to those of 100% long equities might be inadequate if the underlying risk factors associated with the hedge fund’s strategy are not equity-related. In other words, if a hedge fund invests in niche credit derivatives or various commodities, then it is clearly not accurate to compare its returns to those of an equity index. Since returns are a function of an investment’s underlying characteristics, one should aim to compare returns on an apple to apple basis. For instance, quantitative and systematic hedge funds (think of the renowned Medallion fund from Renaissance Technologies or any absolute return fund from Two Sigma, to name but just a few in the business) should be compared to an absolute return benchmark (say 7% per year net of fees) since they rely extensively on statistics and technology. Additionally, distressed funds (non-equity) and fixed income arbitrage firms have little in common with equities and thus cannot be compared to an equity portfolio. As such, some hedge fund styles including but not limited to: quantitative, systematic, managed futures, distressed (non-equity), fixed income arbitrage and high yield should not be compared to 100% long equities given their respective nature and the asset class they invest in. To use Mr. Asness’s words, that would indeed be “flat-out silly.”
Now, let’s examine in detail the hedge fund tilts that can, and should, be compared to 100% long equities. There are many and they are varied.
Activist Funds: These funds tend to make large investments in target companies (which most often trade on a stock exchange, such as the NYSE or NASDAQ) with the intention of participating in the firm’s management and decision-making process. Some of the most famous firms include Icahn Enterprises, Pershing Square Capital Management, Elliott Management Corporation and Starboard Value. Since activist funds invest in publicly-traded companies, it implies that their returns should be compared to those of a corresponding equity index. Additionally, these funds tend to have low leverage and often are long-only, which makes them very close to traditional stock pickers (who themselves are compared to the market’s returns). Finally, some activist hedge funds such as Pershing Square measure their own performance to that of the S&P 500 Index, thus nullifying Mr. Asness’s assertions that “comparing hedge funds to 100% equities would be a bad comparison at any time.”
Long Short Funds and Equity Market Neutral: Long-Short Equity is a directional strategy that involves taking long and short positions in the market. The goal is to take advantage of differences in returns between sectors (long technology and short retail), risk factors (long size and short value), geography (long Japan and short Europe) or other. Equity Market Neutral funds use a similar approach with the sole exception that they focus on maintaining a net exposure of zero (as many longs as shorts). Mr. Asness is right in claiming that an appropriate benchmark for long/short funds would be 50% exposure to stocks. However, one could also make the argument that these two strategies rely on the equity risk factor and thus should earn a premium commensurate with their full exposure to equities. That is to say that, if you go long and short, you should be compared to the entire stock exposure (long + short), not just the net position (long – short). I’ll explain with an example. Let’s assume that we have a Long-Short Equity hedge fund with $100 million in assets under management (AUM). Also, let’s suppose that no fees are paid and that the hedge fund has a short cash position (due to brokers), as well as a short stocks position (securities sold, not yet purchased) and a Total Equity of $10 million. A summary balance sheet would look like this:
Liabilities + Equity
$140 million (investments in securities)
$90 million (securities sold, not yet purchased)
$20 million (cash and cash equivalents)
$60 million (due to brokers)
Total Liabilities = $150 million
Total Equity = $ 10 million
Total Assets = $160 million
Total Liabilities and Equity = $160 million
Gross exposure = 140 + 90 = $230 million (compared to $100 million in AUM)
gross leverage = 230 / 100 = 2.3x
Net exposure = 140 – 90 = $50 million (compared to $100 million in AUM)
net leverage = 50 / 100 = 0.5x
Long-only exposure = $140 million (compared to $100 million in AUM)
long-only leverage = 140 / 100 = 1.4x
In this example, the hedge fund has Mr. Asness’s required 50% exposure to equities (net leverage of 0.5x). However, compared to the assets under management of $100 million, the total exposure to equities is $230 million, resulting in a gross leverage of 2.3x. Hence, one could argue that the hedge fund returns should be compared to those of a 230% exposure to equities (think leveraged investments that provide leveraged equity exposure: ProShares Ultra S&P 500 or Credit Suisse FI Large Cap Growth Enhanced ETN | FLGE). The signs of the positions (long or short) do not matter in this case whereas total exposure does (long + short exposure to equities). In other words, the 230% benchmark exposure to equities should be the required compensation for the implicit leverage associated with the shorts (securities sold, not yet purchased) and the borrowed stocks (due to brokers). The argument would be similar in the case of Equity Market Neutral hedge funds.
Emerging Markets: Emerging market hedge funds investing in equity securities should be compared to 100% long equities given that these funds usually take long positions. Indeed, short-selling is less prevalent in emerging markets compared to mature markets, such as the U.S. or Europe. Additionally, emerging markets offer (on average) lower liquidity, making it harder to short stocks, increasing borrowing costs and thus making short-selling less appealing. Finally, even in countries where short-selling is allowed, the practice is limited. As a result, emerging market funds should be compared either to the equity index (or indices) of the emerging country they invest in or to an equity index made of multinationals headquartered in developed markets that have a significant exposure to the corresponding emerging country (think about Nestle for example).
Now, let’s look at hedge funds with numbers (i.e. let’s use some hedge fund returns and analyze them) as Mr. Asness would likely argue that I purposely selected specific hedge fund strategies to fit my own narrative. Now with the data: I collected hedge fund returns from the Credit Suisse/Tremont Hedge Fund Index database while getting the returns for two equity indices (S&P 500 Index and S&P 500 Total Return Index) from Bloomberg. The S&P 500 Index (“SPX Index”; light red in my graphs) and the S&P 500 Index Total Return (“SPXT Index”; dark red in my graphs) will serve as benchmarks (for practical purposes, I assume here that hedge funds that can be compared to equity indices can be compared to the S&P 500 index or its total return version). The total return version of the S&P 500 Index will be useful in accounting for capital distributions that are directly reinvested by the fund manager (generally, hedge fund investors do not receive dividend payments from the securities purchased by the fund manager: the distributions are reinvested by the general partner into new or additional positions). Furthermore, I performed my analysis over two different time-horizons: 1994-2018 (this is as far as we can go for hedge funds in terms of reliability) and 2009-2018 (the bull market that started after the Global Financial Crisis or “GFC”). Finally, with my two different datasets, I compared hedge fund returns graphically (Graph 1 and Graph 2), and numerically (Table 1.1, Table 1.2, Table 1.3, Table 2.1, Table 2.2, and Table 2.3).
At the beginning of his paper (lines 5-6 in the first paragraph to be exact), Cliff Asness mentions that comparing hedge fund returns to those of an equity index, such as the S&P 500 post GFC, is inadequate because the comparison would be “done over a cherry-picked time period” leading to an inevitable underperformance for hedge funds. Graph 1 below illustrates Mr. Asness’s point:
Clearly, hedge funds have not been able to keep up with the S&P 500 Index over the last nine years (2009-2018). Indeed, Table 1.1 indicates that hedge funds returned on average 6.36% (median return) compared to more than 15% per year for the S&P 500 Index and its total return version over the same period. Even so, not everything is bad for hedge funds as some funds were able to deliver alpha (excess return over the market index) to their investors. For instance, looking at Table 1.2 and Table 1.3 (see Appendix for both tables), Convertible Arbitrage, Fixed-Income Arbitrage, and Multi-Strategy delivered an alpha above 5.5% annually with a relatively limited exposure to the market (beta less than 0.2; green colour in Table 1.2 and 1.3).
Unfortunately, this accomplishment has been overshadowed by a significant underperformance of Managed Futures and Event-Driven (Risk-Arbitrage) strategies (orange color in Table 1.2 and 1.3) as well as a complete capital destruction by the Dedicated Short Bias tilt (red colour in Table 1.2 and 1.3) which managed to cost investors 20% a year (technically the median return is 19.80% as is seen in Table 1.1 below) for providing investors with a negative beta (respectively negatives betas of -0.85 and -0.85 in Table 1.2 and 1.3). Additionally, since I look at the median return, this means that statistically, half of the funds are below that threshold (we have thus some real “losers” among these underperformers). Negative beta is nice (when the market goes down, your portfolio goes up, thus hedging/reducing your risk). However, a negative beta at that cost will get you nowhere (an investment in U.S. T-Bills would have performed better even in the case of negative interest rates). Hedge funds hedge: “it is in the freakin name!” Mr. Asness says. But here it is not so much hedging as it is simply destroying investors’ capital (very efficiently I might add). Finally, I will overlook the survivorship bias that must be present in this strategy as it is very unlikely that investors would sit idle and not try to pull their money out of short bias funds.
Table 1.1 (2009 – 2018 Summary Statistics)
We saw a widespread dispersion of hedge fund returns over the 2009-2018 period with some funds adding value (a little) while others just systematically destroyed capital (Dedicated Short Bias funds). Additionally, the point was made that no strategy was able to match the market’s return over the last nine years. Since the 2009-2018 period constitutes the longest bull market ever experienced in financial history, I ask myself: what about bear markets? What about extending our investment horizon to 1994 to include stressed periods? Would the performance of hedge funds be affected? If so, how? To answer these questions, I proceeded like before, graphing hedge fund returns with those of my two equity indices, calculating summary statistics for all hedge fund styles and running a regression of each strategy’s excess return on the returns of the S&P 500 Index and its total return version.
Looking at Graph 2 above, the picture changes dramatically. Several hedge funds actually do stand the comparison with equities (many beat the S&P 500 Index net of fees while Global Macro was the only strategy to end higher than the S&P 500 Total Return Index). What’s more, hedge funds beat equity indices with a lower exposure to the markets (all funds reported betas lower than 0.5 in Tables 2.2 and 2.3). Furthermore, three strategies stood out: Event-Driven (Distressed), Global Macro and Multi-Strategy (green colour in Tables 2.2 and 2.3) delivering an annual alpha above 4.5% to their investors (see Tables 2.2 and 2.3 in the appendix). As a result, over an extended investment period, hedge funds make sense as a hedging tool (although most of them lost money during the GFC so they probably do not hedge as much as we think they do) with “good returns” and low market exposure.
A quick takeaway on Dedicated Short Bias funds (red colour in Tables 2.2 and 2.3): this is the strategy that benefits the most from extending the investment period. Indeed, instead of losing 20% per year on behalf of their investors, short bias funds now only lose 10% annually (see Table 2.1 below). The performance just improved by twice as much! Ironically, Dedicated Short Bias capital allocations should be privileged among hedge fund investors as markets get more and more expensive.
Overall, although a long investment period supports hedge funds as an efficient asset class, hedge funds tend to underperform on average (net of “incredible” management and performance fees) equity indices. Furthermore, they are not losing billions of dollars of American wealth as is often portrayed (not all of them at least). They even did better than equity indices over the 1999-2007 period (what one would call the “golden age”). However, there is no doubt that over the last nine years, hedge funds have not stood their ground (performance-wise) compared to equity indices such as the S&P 500 Index. This is particularly detrimental to pension funds, endowment funds and other investors that allocate portions of their portfolios toward hedge funds in order to fund their future liabilities (pension benefits) and reduce their market exposure.
Table 2.1 (1994 - 2018 Summary Statistics)
Finally, I will conclude my analysis (and my arguments as to why certain styles should be compared to equity indices) with two points. First, if Mr. Asness himself admits (probably to his own disappointment) that “hedge funds as a whole are now much closer to regular old traditional active stock picking”, then it implies that returns from hedge funds ought to be compared to 100% long equities since active stock pickers themselves are compared to market returns. Second, in one of his earlier papers, Do Hedge Funds Hedge?, Mr. Asness describes hedge funds in the following terms: “hedge funds can be viewed as selling a bundled package that includes (in proportions that vary across managers) 1) an S&P 500 index fund (or some other equity index fund) and 2) some manager skill”. It is thus surprising to see such a dramatic change of mind. Logically, if the “bundled package” includes some exposure to an equity index fund, then part of the benchmark should be made of 100% long equities. The question would then be: by how much?
All is not lost for hedge funds and their investors. Since this analysis of hedge fund returns was made with averages (the data is from hedge fund indices), it is statistically guaranteed that at least some managers (a positive non-zero number of them to be exact) will be successful in delivering above-market performance with lower risk to their investors. Thus, investors should focus on selecting best–in-class funds, implementing an effective due diligence process, but more importantly, on understanding the particular characteristics of each strategy.
1 See The Hedgie in Winter
2 It turns out that Schwab offers exposure to the S&P 500 index for even less: https://www.schwab.com/public/schwab/investing/accounts_products/schwab_index_funds_etfs
5 See The Hedgie in Winter page 2, paragraph 3, line 1
7 See https://www.aqr.com/Insights/Perspectives/The-Hedgie-in-Winter Note 11 on page 3 describes Long/Short Equity funds’ beta of 0.5
13 See https://www.aqr.com/Insights/Perspectives/The-Hedgie-in- Winter page 1, paragraph 1, line 5
14 See https://www.aqr.com/Insights/Perspectives/The-Hedgie-in- Winter page 2, paragraph 3, last line
15 Mathematically, I took the returns of each hedge fund strategy, subtracted the risk-free rate and run a regression on the excess return of the S&P 500 Index (and its total return version) over the risk-free rate. For example: Risk Arbitrage - Rf = alpha + beta*(S&P 500 Index - Rf) + error term
19 See https://www.aqr.com/Insights/Perspectives/The-Hedgie-in- Winter page 8, last paragraph, last line
Table 1.2 (2009 - 2018 regression over the S&P 500 Index’s excess return over the risk-free rate)
Table 1.3 (2009 - 2018 regression over the S&P 500 Total Return Index’s excess return over the risk-free rate)
Table 2.2 (2009 - 2018 regression over the S&P 500 Index’s excess return over the risk-free rate)
Table 2.3 (1994 - 2018 regression over the S&P 500 Total Return Index’s excess return over the risk-free rate)
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am not an investor in any of the funds mentioned in this article (though I wish I were).
I have no plan to initiate an investment in any of the funds mentioned in this article (I do not qualify).
This article is from Pierre-Axel Gide, Senior Analyst, Risk Management at National Bank of Canada. Comments herein are his own.