Hedge funds are coming off their worst half year since 1991. This according to Hedge Fund Research. The HFRX Global index is down (3.02)% for this year and the HFRI Index is down (1.04%). In comparison, the S&P500 is down 14.17% YTD.
This raises a good question. What are hedge fund managers doing differently in a bear market than they did in the bull market? Answering this question evokes both a qualitative and quantitative response. From a qualitative side, it seems clear that hedge fund managers are rightfully paying much more attention to leverage and Risk Management. I hear this in conversations with hedge fund managers across a spectrum of strategies. Anecdotally, you can also see an upswing in articles, news, blogs, etc.… dedicated to risk management and transparency. Even quasi-governmental reports such as the President's Working Group on Financial Markets and London’s Hedge Fund Group are dealing with leverage and risk.
From a quantitative side, answering this question becomes much more difficult. So, I decided to compare Betas for various hedge fund strategies from a Bull Market Period (Jan 2005 – June 2007) to that of a Bear Market Period (Jan 2008 – July 15, 2008). I am loosely equating changes in Beta with aggregate changes in management styles across the industry. Clearly, change in Beta is not a predictor at the manager level. However, as a proxy for industry changes, I think the comparison is interesting.
I used daily rate of returns [ROR] from Hedge Fund Research HFRX indices for 2008 to calculate 2008 Bear Market Betas and monthly ROR from January 2005 – June 2007 for Bull Market Betas. S&P500 returns are used as a proxy for return of the financial markets. The chart below shows my results:
All sectors have a significantly lower Beta in a bear scenario. This makes sense on two levels. First off, in a bull market, you would expect both the S&P and the underlying index to move somewhat together. If an index yields a positive monthly return and the market have a positive return, then a higher Beta or the slope of returns will reflect that everyone is making money. Likewise, during a bear market, you would expect a lower Beta as the relative change in short positions decouples a Fund’s return to that of the overall market.
These numbers reflect that hedge funds, while not always generating absolute returns, can do a good job protecting assets. Furthermore, looking at the individual sectors may be revealing. Macro funds which had a long bias in a bull market has moved to a short bias in a bear market. This may hold true even for Equity Market Neutral funds. Surprisingly, Market Directional lowered Beta significantly but does not show a short bias.
Again, I am being loose with my interpretation of Beta here and overreaching with comments on the long and short bias. However, this chart is interesting to me. It shows that fund managers as a whole are adapting to market changes. The last point is this. Returns may have been the worst in 17 years, but every cloud has a silver lining. Following that horrible half-year in 1991, funds had their best returns (up 16.7%) in 1992. Given the ability for fund managers to adapt, when this ship stops sailing into the wind, funds should be in a good position to generate high returns.