Earlier today, we brought you some highly amusing excerpts from a recent BofAML note.
You’ll recall the following main points:
- Shorts squeezed by “Trump Rally” in Q4 2016. Based on the quarterly 13F filings and estimated short positions of the equity holdings of 958 funds, we estimate that hedge funds short-covered the most stocks during Q4 2016 since the end of 2009.
- HF least net short ETF since 2012; record long positions. Hedge funds increased their ETF long notionals by $7.4bn to a record high of $45.1bn (from Q2 2011), while decreasing their ETF short notionals to the lowest since Q2 2013.
- Hedge fund net short notional in ETFs fell to the lowest since 2012, driven by equity class which saw the least HF short in record.
The implication there is obvious. Having failed miserably when it came to anticipating the post-election Trump rally, hedge funds turned relatively (although still characteristically net short) bullish equity ETFs. Here’s the graphic that illustrates the latter two bullet points:
Well consider that as a prelude to the following out earlier today from Bloomberg’s Cameron Crise who notes that “hedge funds’ alpha is vanishing as they turn to indexing.”
Two of the main issues confronting asset allocators these days are the benefits of active vs. passive investment styles and the utility of investing in hedge funds. At the heart of each of these is the question of whether it’s possible to beat the markets consistently. I decided to have a look at whether hedge funds can really outperform.
- The HFR equity hedge fund index, which provides monthly readings on hedge fund performance going back to 1989, was the basis for my analysis of the issue. While it is true that such an index has survivorship and selection biases, so does the S&P 500: companies that quit making money get booted out and replaced with those who do.
- Over the period of my study, the hedge fund index had an annualized return of 10.9% vs. total returns for the SPX of 9.1%. At the same time, the annualized volatility of hedge funds was 8.7% vs. 14.5% for a passive equity index investment. Game, set, and match to hedge funds, right?
- Not quite. What we’re looking for is consistency over long periods of time, so we need to dig a bit deeper. I compared 5-year rolling total returns of the S&P 500 with three different measures of hedge fund performance:
- The HFR index, as published
- The HFR index adjusted to generate the same level of volatility as the SPX
- The as-published HFR index adjusted to account for performance before fees (assuming a 2 and 20 payout structure), which ostensibly measures the underlying skill of the managers in the index
- In looking at the data, a few things become immediately evident:
- Historically, hedge funds have demonstrated a significant ability to outperform the S&P 500
- That ability seems to have vanished for much of the last decade
- The “lower vol” offered by hedge fund indices seems to be largely a function of fees.
- The deterioration in hedge fund performance over the past several years is really notable, and almost certainly explains the pushback against fees and the industry in general.
- I regressed hedge fund returns with SPX returns and compared the correlation to a measure of hedge fund outperformance. The results were breathtaking.
- Hedge funds’ returns have started to track the SPX more closely. As that happens, their ability to outperform has collapsed. This makes intuitive sense; there’s no way you can beat an index when you’re paying 2 and 20 on an investment vehicle that largely replicates the return of the index!
- It’s hard to know which way causality works — are funds underperforming because they hug the index, or do they hug the index because they’re underperforming? There’s probably a little bit of both at work.
- The investment landscape has clearly changed since the crisis, both in terms of allocators’ willingness to tolerate drawdowns and the hurdles required to launch a fund with a modest amount of AUM (smaller funds typically outperform their larger brethren).
- Either way, the industry probably cannot go on as it has been. Hedge funds have demonstrated the utility of active management in the past; if they’re going to outperform in the future, they need to be willing to take risks — and investors need to be willing to go along for the ride.