I am often fascinated by investor perception and behavior. I notice it everywhere and study it always. What a person believes makes their world what it is and how they see things. It can also explain their own poor results. You see, if the majority of individual investors and professional investors actually have poor performance over long periods (as evidenced by Dalbar and SPIVA®) they necessarily must be doing and believing the wrong things.
I just came across something that said “Why are hedge fund indexes performing so poorly?”. My first thought was “Are they?”. There are a few different hedge fund indexes, but I use the Barclay Hedge Fund Indices because it can include more than 1,000 funds each month across a wide range of strategies.
The Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. The index is simply the arithmetic average of the net returns of all the funds that have reported that month.
As you can see below, the Barclay Hedge Fund Index, which is the average return of all hedge funds in the Barclay database, has gained 5.22% year to date through August. Is 5.22% a “poor” return when the risk free rate on short-term T-Bills, money markets, and CD’s are near zero? I don’t think so. But, if you compare it to the highest returning index you can find maybe you’ll perceive it as “poor”. For example, the stock market indexes are so far “up” double digits this year, but they can reverse back down and end the year in the red. Stock indexes are long-only exposure to stocks so their results reflect a risk premium earned for owning stocks with no risk management to limit the downside. I don’t know anyone who thinks the stock indexes have created the kind of risk adjusted return they want after declining more than -50% twice the past several years. If they want to compare “hedge funds” to a long-only stock index they should consider focusing on hedge funds that focus on stocks.
As you can see below, the hedge fund index includes a wide range of alpha strategies. The Equity Short Bias is one of only two that are down year to date and that is expected: they are short stocks and stocks have gained this year, so these strategist that short stocks have lost money. Emerging Markets is the other that is down, which is not terribly surprising since most emerging markets are down. They have still managed risk: through August the Emerging Markets Hedge Fund Index is down -1.73% while the iShares MSCI Emerging Markets ETF is down -13.17%. I’m sure any of those hedge fund managers who are down don’t think that’s “good”, but its just a short period of time.
Investment managers are to compare their performance to something to illustrate the general market and economic conditions over a period. Since my investment programs don’t intend to benchmark any indexes, we often use the Barclay Hedge Fund Index as a comparison of this “alpha index” to our programs.
In the chart below, we have compared over a full market cycle the Barclay Hedge Fund Index, Dow Jones Global Moderate (a monthly rebalanced index of an allocation across 14 global indexes that are 60% global stocks, 40% global bonds), and the S&P 500 stock index The blue line is the Barclay Hedge Fund Index. Keep in mind that the hedge fund index is net of hedge fund fees while the S&P 500 stock index and Dow Jones Global Moderate does not reflect any fees. If an investor used an adviser, they would pay a management fee, index fund fees, and trading cost, so the net return would be less. Recently, it has “lagged” the other two, but over the full cycle, its risk/reward profile is significantly superior. Though they all ended with about the same total return, the Barclay Hedge Fund Index declined -24% peak to trough during the 2007 – 2009 bear market. That -24% is compared to -38% for the Dow Jones Global Balanced 60/40 index and -55% for the S&P 500 total return (including dividends). That is the advantage of “active risk management” many hedge funds attempt to apply. Look closely at the chart below and decide which experience you would have rather had. And then, consider that it’s important to view the full picture over a full market cycle rather than focus on short-term periods.
As to why the Barclay Hedge Fund Index has lagged stocks lately?
They are supposed to. Hedge funds as a group, as measured by a composite index, are investing and trading long and short multiple strategies across multiple markets: bonds, stocks, currency, commodities, and alternatives like volatility, real estate, etc.
You may also consider that hedge funds are generally risk managers (though not all have that objective). If you look at the end of the last bull market in stocks (late 2007) the hedge fund index lagged 100% stock indexes then, too. You may consider that risk managers are actively managing risk and they could be right in doing it now considering the stage in the cycle. It’s probabilistic, never a sure thing. It worked the last time. Some hedge fund strategies begin to reduce their exposure to high risk markets like stocks after they have moved up to avoid even the early stage of the decline. By doing that, they “miss out” on both the final gains but also the initial decline after a peak. Others wait until stocks actually reverse their trend, which means they’ll participate in some of the initial decline when it happens.
You may also consider that people bragging about the gains to long-only stock indexes that have no downside protection may be another sentiment indicator. Historically, it seems that about they time they get to bragging and become complacent the trend turns against them…
Note: you cannot invest directly in any of these indexes.