Wednesday, 10 February 2010

Performance of Equity Hedge Funds versus Equity Markets This Year

Investors don't need investments in equity hedge funds on a multi-month basis when equity markets are in a multi-year bull market. At the margin equity hedge fund holdings would moderate a monthly return series of pure fully-invested equity market exposures. In prolonged bull phases equity hedge holdings would produce slightly lower losses in the down months, during the pauses that refresh in major bull markets. But equity hedge fund exposure will not produce positive absolute returns in down months of a prolonged bull. This is shown in the first graphic below.

The first graphic (courtesy of Bloomberg LLP) shows the price series and relative returns of HFR's Investible Equity Hedge Index and the S&P500. HFRXEH is a good proxy of US-based equity hedge managers, and has the distinct advantage for hedge fund watchers of being a daily return series. The top half of the graphic shows two line charts for the two indices. The green shaded part of the lower half of the first graphic shows the relative performance of equity hedge funds against the equity market. When the line in the lower half moves up equity hedge funds are out-performing equity markets, and vice versa.

So the lower half of the first graphic shows that equity hedge funds under-perfromed the multi-year equity bull market of 2003 to August 2007, then out-performed the equity market into the market low of March 2009.

The second graphic here tells the same story over the last 17 months. Simply put, equity hedge fund managers as a whole cannot match a market rally of 50%-plus from the low that turns on a dime.

Amongst the questions I want to address here is how have equity hedge funds done this year, and what should investors in equity hedge funds have expected, given the market conditions experienced.

Over the year-to-date (up to and including Monday the 8th of February) the HFR Equity Hedge Index has fallen 1.6%, and over that time the S&P has fallen 5.2%.  There have been two distinct phases for the equity market in the year to date period: stocks rallied 3.1% from the start of the year to the S&P high on the 19th of January, and then stocks fell 8.1% to the 8th of January. The high for the HFR hedge fund index came a week before the price peak of the S&P500: the inference being that equity hedge managers were already reigning back net equity market exposure as the market approached its peak. Further, the relative movements of the hedge fund index to the stock market index sugggest that in the first two weeks of the year equity hedge fund managers as an aggregate had a net market exposure of around 80%. From the stock market peak on the 19th of January to the 8th of February the decline in equity hedge fund NAVs suggests that the net exposure of equity hedge funds in America was just under 60%.

The returns from equity hedge funds this year will have come from both stock selection and net market beta, and at the index level it is not possible to break that down (ask your manager for details). The evidence from the year to date numbers so far is that equity hedge managers have reduced their net exposures going into the fall in stock prices and mitigated the losses of the capital of their investors through so doing.

Addendum: The BoA/Merrill Lynch Hedge Fund Monitor for 8th February estimated that (globally) equity long/short funds had cut market exposure to a net 27-28%  in the first week of February. If so that would be the lowest net exposure to markets since May of 2009.

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