Don’t Be Fooled: This is No Hedge Fund Replication

On Wednesday, the Wall Street Journal ran a blog on replicating hedge fund returns.  The technique proposed by Tim Edwards, an analyst with S&P Dow Jones Indices, could not be simpler.  He constructed a model consisting 50% of the returns on the S&P U.S. Aggregate Bond Index and 50% on those of the S&P Global 1200 Index, rebalanced monthly, charging a 1.5% annual management and a 15% performance fee.  He compared it with the HFRI Fund-Weighted Composite Index, which is constructed from the reported returns of hedge funds worldwide.  The blog provided this graph of the model’s monthly returns against the benchmark:

No analysis was provided, but the graph is all that is needed to show that the series are tightly correlated: from the look of it, probably >0.9.  Note that the replication was consistently and significantly more volatile than the index it allegedly replicates.

Mr. Edwards is quoted saying “The average hedge fund looks like a fixed blend of cheap investments, at high cost.”  He has not demonstrated this.  What he has shown is that an unweighted index aggregating >2,000 managers’ returns will, over short periods, resemble broad market indices.  It does not analyze the funds’ performance over periods meaningful to investors, and over which the funds’ cumulative returns and volatility would differentiate them from an index.  Mr. Edwards’s model replicates the mean fund and chain-links its return to that of the next month’s mean return: it does not replicate any particular fund, so there is no sense in which it replicates an “average” hedge fund.  Volatility lowers compounded returns, so his model underperforms even that notional fund on both absolute and risk-adjusted bases over periods of a year or more.

That an average of many funds’ returns resembles such a model over short periods is not surprising.  The World Federation of Exchanges’ June report counted 42,759 companies worldwide.  The overwhelming majority of them would not attract a fund’s attention, so hedge funds’ portfolios inevitably overlap.  In a given month, returns on the Russell 1000 are similar to the average of all large cap U.S. equity funds, too.  But hedge funds’ returns disperse widely around the mean and are negatively skewed: the return on the median fund (the one outperformed by as many funds as it outperforms) is higher than the mean return of all funds.  Based on the graphic with which we are provided, Mr. Edwards’s technique creates a roughly sixtieth percentile hedge fund clone, in a period of consistently rising markets that favor a long-only comparison.  This is hardly impressive.

There are many issues regarding indices that purport to measure hedge fund returns.  They include survivorship bias, whether the “best” funds report their returns at all, and whether funds that do report are honest (it is in their interest to report returns which flatter their actual performance).  And quite apart from issues with indices, there are plenty of reasons to be skeptical about hedge fund.  The extent to which leverage parades itself as alpha is the most important one.

I am skeptical about “hedge fund beta,” and consequently doubtful about any approach to hedge fund replication based on aggregate fund returns rather than the returns of a specific fund.  The high dispersion of hedge fund returns indicates that the mean of those returns has limited value as a series to replicate: any data can be correlated with sunspots, Elvis sightings, etc., and data-mining will always find a series it resembles.  A specific fund at least provides a meaningful basis for comparison with other financial series, and one that might be worth the trouble of using factor analysis or replicated trading strategies, to replicate.  Strategies based on an algorithmic model of a fund's trading strategy may also hold some promise.  I am nevertheless skeptical.  But I am not skeptical about crude strategies such as that proposed by Mr. Edwards: it is not a replication at all.

Hedge Funds to Increase their Equity Exposure?

A review of third quarter reports from hedge funds finds that, at least as of September 30, many event-driven managers continue to seek much of their equity-like exposure through positions in distressed or discounted but still performing credits. The extent to which this is a deliberate choice based on strategic considerations is not in all cases clear.

Strategies of seeking equity-like exposure through the credit markets has had much to recommend them over the last couple of years, and dedicated investors in distressed situations are likely to continue to seek such exposure. But returns on these investments tend to be slow to develop and “lumpy.” It could be that, in many cases, the continued predominance of credits in event-driven portfolios simply reflects the fact that investments made a year or two ago have yet to achieve their return targets. Retention of a bias toward credits could also be a matter of liquidity: even at the best of times, most such instruments are fairly illiquid, and if the prospect that they will achieve their return targets are fading, demand for them is likely to be even less. Managers who might otherwise allocate away from them may be deterred by the necessity of having to accept steep discounts in order to liquidate them.

Distress and discounted performing credits are always with us, but their supply varies, as does their inherent attractiveness. The opportunity to acquire the paper of sound borrowers at steep discounts occurs only during times of crisis – the credit spreads on such paper have narrowed since the Credit Crunch, and where liquidity allowed, most such positions acquired at that time have probably been realized. There is always new supply of distressed debt, as previously healthy firms encounter difficulty, but the quality of a borrower that enters into distress at a time of relative economic calm is rather different from that of a borrower whose distress results from global macroeconomic dislocation. Widespread distress offers opportunity to hedge funds that are not distressed debt specialists. As the new supply of distressed debt arises increasingly from firms that fall into distress for idiosyncratic, firm-specific rather than macroeconomic reasons, fewer managers other than distressed debt specialists will be attracted to it.

All this suggests that many hedge funds’ allocation toward credits will decrease over time, almost certainly in favor of an increased allocation to equities. The credit positions they have built over the last few years will either attain their return targets and be liquidated or gradually be abandoned. Specialists will continue to plough the debt furrow, but the majority of event-driven managers are likely to find more opportunity in trades employing equities rather than equity-surrogates. Other factors support this trend – most notably the high levels of liquidity on corporate balance sheets. This encourages corporations to create opportunities for merger arbitrage, a tendency that is already clearly in place, and in an environment where arbitrageurs face less competition from private market buyers than they have in the recent past. Where they are not used to finance acquisitions, cash hoards invite corporate activism, in which many event-driven managers delight. The U.S. environment for activism will improve next year, thanks to changes to proxy rules. In the next year or so, strategies involving equities can be expected to bulk larger in event-driven portfolios than they have recently.