Recent research into the performance of major US Hedge Funds has revealed a substantial degree of under performance by these funds when compared to the S&P 500 indices and their more staid mutual fund rivals. The research which was conducted by Goldman Sachs and others shows that the average Hedge Fund has underperformed the S&P 500 by a staggering 80% in 2013 and that figure is up by a margin of 23% since the 65% underperformance that was in situ up to May of this year.
Given the “master of the universe” status accorded to many of these managers, it’s time their funds investors starting asking just what is going on here and whether the reputations and fee structures that are enjoyed by the funds are justified…
To answer these questions, we need to look much closer at both the Hedge Funds themselves and the market place and economic climate they are currently operating in. Firstly the Goldman survey is not necessarily comparing apples with apples for the simple reason that many of the largest hedge funds do not employ a typical long/short equity strategy, rather they use a Global Macro style. Global Macro funds sprung to prominence in the early 1990s when the Hungarian born investor George Soros forced the UK to remove sterling from the ERM (or European Exchange Rate Mechanism as it was known) a fore runner of today’s single European currency.
These funds look for mispricing / misallocation opportunities between assets and asset classes, for instance between currencies and interest rates or commodities and bonds. Having identified these opportunities, they place large directional and often long-term bets that will produce outsized rewards as these disparities widen or narrow (depending on the funds view). A comparison of a Macro Funds performance against a stock index over 8 months may not tell us very much if the Funds time horizons are say three to five years . However, its also true to say that there are also many hedge funds that do employ long short equity strategies. Indeed, the Goldman’s research reports that hedge funds have an overall exposure to US equities of some US$1.5 trillion (US $1 trillion on the long side and $500billion to the short). To put that in context, the current market cap of Exxon Mobil the largest US company is a little over US$380 billion. Hedge Fund exposure to US equities is therefore substantial but not necessarily significant in the wider scheme of things.
A rising tide lifts all ships Hedge Funds?
US Equity Markets have certainly enjoyed a stellar run over the last 8 months and over a full 12 months rolling basis with only 50 stocks within the top 500 US equities showing a 12 month negative performance of -3%. In fact, in a quirk of statistics, the average performance for an S&P 500 stocks year to date is round + 20% – much more than the YTD return of around + 17%. Hedge Funds are not actually so called ‘beta chasers’, that is to say that they do not, for the most part, seek to capture broad based tidal flows in stocks and stock indices rather that they prefer to look for the elusive “alpha” – true absolute outperformance.
If beta is thought of as that portion of stocks performance that can be directly attributed to its propensity to track the wider market, then alpha can be considered to be its intrinsic performance i.e. that which sets it apart from the crowd. Hedge Funds are, for the most part ,contrarian, and take contrarian positions compared to the wider market. That’s not to say of course that Hedge Funds don’t form crowds they do, but they tend do so in opposition to more traditional investors.
That contrarian nature has proved to be expensive so far this year the survey data reveals. It shows that some of the most highly shorted stocks in the USA this year have also been some of the best performers. Readers may recall our recent comments about the reduced liquidity in Blackberry since the turn of year and what that would mean if the large outstanding short position needed to be covered quickly. The Goldman’s research revealed that a sample 50 US companies with market caps of a billion USD or larger and where there is a significant current short position in their equity had in fact outperformed significantly, rising by 30% year to date on average and creating a double whammy for the Hedge Funds.
Most shorted stock performance versus the S&P 500 since November 2012
QE has distorted the playing field
In fact, hedge funds have underperformed the S&P 500 over the last five years it turns out and this of course coincides almost exactly with the introduction of a zero interest rate policy by the FED and the addition of almost unlimited liquidity such as QE and asset purchase programs. There is no doubt to my mind that policies employed by the Federal Reserve and other central banks around the globe in the last five years have distorted markets to the extent that previously successfully strategies employed by hedge funds no longer work effectively if at all . One need only look at the continued poor performance of Man Financial’s AHL Fund a black box quant fund that cannot reconcile itself to cheap money and inverted yield curves and deflation. True, one would have thought that the bright minds at leading hedgie’s would have come to terms with the status quo and reprogramed their models, but it may well be that at the largest funds, issues of scale (deployment of cash ) mean that the only strategy they can employ is the one they are current employing.
This of course is one the primary advantages of our Titan funds – we do not run (yet!) billions of pounds where it is difficult to allocate capital, but are rather like the flyweight boxer – nimble and able to move at speed. This is one fact that has allowed us to reap exceptional outperformance against our benchmarks this last 2 months since official FCA authorisation – that and the correct asset allocation calls of course.
Asset allocation with hindsight
With the benefit of hindsight, an investor looking back over the last five years, will probably and rightly conclude that he would have fared much better by placing his money into passive index tracking assets rather than actively managed hedge funds and to have paid the commensurately lower feed associated with ETFs mutual funds rather than the hedgies higher fees. Of course had he looked back over a prior five year period he would have been keen to have been invested with our friend Messrs Paulson and others in the short subprime trades that proved to be so lucrative as that bubble imploded into the credit crunch. And there’s the rub – hedge funds are not trend followers, they don’t typically do well in periods of high directional and asset correlation. They tend to benefit from the end of trends and the beginning of a counter trend, unwind or ideally collapse of bubbles and high levels of correlation . Given the winds that are currently blowing through emerging markets and related currencies as well as the US bond markets, not to mention the Alice through the looking glass world that is Japan there, is every reason to suspect that another major dislocation could be a under way and the hedge fund asset class is about to return to favour.
R Jennings, CFA, Titan Inv Partners
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