Will the Real Hedge Fund Profile Please Stand Up?

Hedge funds are often touted as absolute performance vehicles, which makes us wonder why they have been getting more and more of the relative performance treatment since their miss in 2008 when they were down alongside stocks. The latest comes from a Dow Jones Credit Suisse press release seen here on Yahoo news:

The Dow Jones Credit Suisse Hedge Fund Index Outperforms Global Equities by More Than Five Percentage Points in August

That’s a cute headline. How about this one? Their hedge fund index was down -2.30% in August.

Now, we’re all for applauding those who manage to lose less than the stock market – and we firmly believe that hedge funds can and will do that consistently. But the problem with saying, “Yes – we were down, but we weren’t down as much as the stock market!” is that you stop being an absolute performance vehicle, and take on a relative performance profile. Absolute performance is supposed to work regardless of the economic environment or whether the stock market is up or down. Relative performance is more a game of trying to beat (slightly) a benchmark.  Absolute performance should not be compared to a benchmark (they set the bar), while relative performance should be at least as good- and never as bad- as the benchmark.

It’s easy to see why hedge funds are trying to say that they’re marginally better than stocks when they’re supposed to be on a totally different level. They want to have their cake and eat it too. They want to market their absolute return profile when making money, yet fall back on their relative performance when losing. Not a bad tactic from a PR perspective, but it doesn’t help the average (sophisticated) investor understand whether the hedge fund he or she is considering will diversify his/her portfolio.  We have made no secret that we don’t believe they will diversify a portfolio. This idea was expanded upon in our newsletter this week. If anything, hedge funds should replace your stock exposure (in our opinion), not try and diversify it.

The astute reader may wonder, How can managed futures talk about “spinning” performance when they’re down for the year, too? AND they’re underperforming hedge funds year to date, as well?

Good question. Yes, managed futures are down for the year, but if you’re trying to determine the diversification value offered by an investment, the better question here is why are managed futures down? They are not down because stocks went down. They are down on their own accord, from doing their own thing. Hedge funds, conversely, are down because stocks are down – making them a beta play (relative performance) instead of and alpha play (absolute performance).

The takeaway here, in our opinion, is clear: hedge funds are not the alternative investments they pretend to be.

If you’re still drooling over the contrast between hedge funds and stocks performance last month, take a minute to think about how managed futures fared in comparison. Managed futures (which we contend is an asset class in its own right), as reported by the same index, generated returns of .25% last month (Disclaimer: Past performance is not necessarily indicative of future results). While the cited press release (which is not a news article, by the way- it’s functionally a piece of marketing designed to make you drool over hedge funds) is quick to point to portions of their industry that performed well last month, isolating Dedicated Short Bias strategy returns in particular, the same could be done for managed futures- with even more drool-worthy results. Barclay Hedge provides the most reflective strategy by strategy break down of any other index, in our opinion, and unlike the hedge fund strategy break down provided by Dow Jones Credit Suisse- where 12 of the 14 strategies, excluding managed futures, had negative returns during August’s roller coaster ride- 5 of the 6 managed futures strategies brought in positive, albeit small, returns for the month.

Disclaimer: Past performance is not necessarily indicative of future results.

Before you start calling foul on the mismatch between Barclay Hedge’s numbers and those reported by Dow Jones Credit Suisse, let’s take a moment for a refresher on how these indices work. Each index you see in the financial world, regardless of what asset class it references, is constructed and maintained differently. They’re intended to provide a snapshot of performance- not a panorama- and much like photos taken from different angles with an actual camera, each angle taken by an index is going to provide a slightly different view. However, even with these slight variations, three of the biggest indices in the industry (Dow Jones Credit Suisse, Barclay Hedge, and Newedge- which we recommend) have consistently reported industry performance with a high level of correlation, giving, in our opinion, the average investor confidence in their credibility and utility.

Do they represent the entire world of possible performance within an asset class? Absolutely not- but compiling that information in a consistent and reliable manner would be next to impossible, and as past performance is not necessarily indicative of future results, AND, in our opinion, managed futures exposure is best captured via managed accounts with individual CTAs instead of managed futures index investing (more on that here), such efforts would be a frustrating waste. That being said, investors should always consider the inherent limitations of the specific index they’re looking at. You can learn more about the differences between the indices Attain references here.

5 comments

  1. […] Continued here: Will the Real Hedge Fund Profile Please Stand Up? « Managed … […]

  2. Lauren,

    You are right about hedge funds’ not being perfectly uncorrelated with the market. On the average equity hedge funds are 50% net long during the past year or so. This doesn’t mean that hedge funds are worse than managed futures or any other “alternative” investment vehicles. It just means that hedge fund investors pay high fees for beta exposure. In other words hedge funds charge more than what they advertise.

    The real issue is whether hedge funds can generate “alpha” despite their high fees. Your numbers suggest that they do. Considering that hedge funds are 50% net long, this has costed them in 2.5 percentage points in August. Since hedge fund index was down 2.3% in August, this implies that their alpha (after fees and expenses) was around 20 basis points in August. Did managed futures generate this much alpha in August?

  3. Thanks for commenting!

    While we can appreciate your point, we have to disagree. The whole point is that they aren’t really alternative investment vehicles because they are beta plays dressed up as alpha. Even if they are half stock beta, half alpha – that is still a lot more stock market exposure than most investors realize, in our experience.

    As for managed futures and alpha – if we assume they have 0 beta, then their alpha would be whatever they returned, +0.11% based on BarclayHedge data showing CTA index up that amount (see our above comments on index limitations). And that is the problem with considering alpha with beta… Hedge funds had a better Alpha reading in August at 0.20 vs 0.11, but were down. Most investors considering alternative investment want and expect alpha without the beta. As August showed, alpha with the beta doesn’t do all that good when the beta brings the returns down.

  4. Thanks Jeff for your reply.

    I agree with you that hedge funds should have increased their fees and eliminated their beta exposures. It isn’t very convenient for hedge fund investors to hedge their beta exposure by themselves, but it is still possible to eliminate most of the beta exposure.

    We did an analysis of hedge fund indexes for several strategies (including Managed futures) and found that long/short equity hedge funds had 0.35% monthly alpha between 1994 and 2010. Their beta was 0.45. Event driven hedge funds had better results though. Their alpha was 0.44% per month and their beta was only 0.25.

    On the other hand managed futures did well too. Their alpha was same as L/S equity hedge funds, 0.35% per month. Their beta was -0.07. Here are the details:

    Hedge Fund Alpha and Beta

    Managed futures seem to be better alternatives to L/S equity hedge funds but personally I prefer event-driven hedge funds to managed futures because of higher alpha. The reason is I can gain negative beta exposure elsewhere to offset the event-driven funds’ beta exposure.

  5. […] Will the Real Hedge Fund Profile Please Stand Up? (managed-futures-blog.attaincapital.com) […]

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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