Thursday, 26 August 2010

Another Year Another Challenge for Funds of Funds

In 2008 the fund of funds industry had a tough time producing returns for investors because only 30% of hedge funds produced a positive return. For 2009 things were tough for funds of funds as they couldn't get out of the hedge funds that had let them down by making losses in 2008, because of limited liquidity in the funds, suspended redemptions, and sidecars. Further, few of the funds which made money in 2008 made good money in 2009. So if funds of hedge funds stayed loyal to their winners of 2008 it probably cost them in 2009. There was even a reversal of the size effect on hedge fund returns in moving from 2008 to 2009. 

Before looking at hedge fund returns in 2010, and factors that will impact fund of funds returns, let's look at single manager hedge fund returns in 2008 and 2009 from an absolute and relative perspective.

2008 was an absolute disappointment in terms of hedge fund returns- a loss of around 16%. Last year hedge funds produced their best returns since 1997, at up 19%, by the Greenwich Global Hedge Fund Index. And year to date through July, the same hedge fund index has a small positive return (up 1%), which is not good in isolation as an absolute return over seven months. 

The returns from equities put the absolute returns of hedge funds into some context. Using the S&P500 as a proxy for the equity asset class, the hedge fund returns of 2008-9 look very different. The S&P500 was down 38.5% in 2008, the year hedge funds at an index level lost 16% in a liquidity crisis with high volatility and fraud in the industry, and even so 30% of hedge funds were up.

In 2009 the S&P500 was up 23.5% and hedge funds were up 19%, which given the constrained directionality (beta to markets) is as good as it gets for the alternative funds. Over 70% of hedge funds produced positive returns in 2009.  

This year the S&P is down 4.3% at the time of writing, whilst representative indices of hedge funds are up a small amount.  However the context for hedge fund returns in 2010 is even tougher in some regards than the previous two years. To begin with, let's look at the trajectory of the equity market this year. Below is a one year chart of the S&P500.

The rally of the second half of 2009 actually peaked in the first few weeks of 2010, and thereafter the stock market has been a rollercoaster of epic proportions, meaning a serious of precipitous falls followed by sharp rises. Monthly index level changes of 7-8% have not been unusual since the outbreak of the Credit Crunch, but the sequences have changed: we had a string of big down months in the bear market to the low in March last year, then a series of big up moves in the massive rally of the last three quarters of last year. In 2010 we have had big up and big down moves alternately. Given that managing the net exposure is typically the biggest risk control variable of most hedge fund strategies (bar the market neutral strategies), this year has been amongst the most difficult market direction background I can recall, as the market was aggressively moving one way and then the other by turns.

Persistence of market movement, or propensity to trend, is different from volatility in traded markets. It turns out that the actual volatility of the S&P500 index, as a proxy for global equity markets, has been both unusually low and then high  this year. The chart below shows 30-day historic or actual volatility of the S&P500.

source: Bloomberg LLP

A level above 25% historic volatility (as opposed to traded volatility) has been uncommon in equity markets, except for short periods, and except for the last two years. The shifts in volatility seen this year would probably have hurt more hedge fund strategies than they helped. Pure volatility strategies should have benefited from the April/May shift in volatility, and the delta hedging of CB arbitrage funds should have had a good background in March and after the June peak in volatility . Overall 51% of hedge funds by number had produced positive absolute returns at the half way point of the year. This hurdle was exceeded by 68% of hedge funds at the end of the first quarter of the year, so the year has got progressively tougher as it has gone on - that falling success rate persisted into the end of August

Hedge Fund Returns by Strategy
source:Greenwich Alternative Investments

Returns by strategy are for the most part marginally profitable or loss making this year. As this is the case, differences in index and sub-index construction and scope have produced different outcomes. What one index provider has as a strategy with a positive return, another shows a negative return for.  Lipper's series of hedge fund strategy indices has only two strategies out of 13 given producing positive returns this year.  Greenwich Global Hedge Fund Indices show only three strategies with negative returns in the YTD (out of a total of 15). Both index providers agree that Long/Short Credit and Convertble Bond Arbitrage are amongst the best strategies for returns so far this year.

Looking across other index providers (Dow Jones Credit Suisse, and it looks as if a small majority of hedge fund indices for strategies produced positive returns in the first seven months of the year. This hit-rate for positive returns by strategy in combination with the dispersion of returns within the strategy has some interesting implications. 

Dispersion of Hedge Fund Returns Within Strategies January-July 2010
source: Lipper, a Thomson Reuters company, TASS database

The dispersion of returns within the investment strategy categories of hedge funds is lower this year than last year. However this year the dispersion ranges for each strategy includes a significantly proportion of negative returns. This is a very different outcome from 2009, when the spread of returns by strategy may have been wider than this year, but returns were overwhelmingly positive. 

The read through to funds of hedge funds will be interesting. Another way of looking at the last two calendar years is that positive returns came from CTA and global macro in 2008, and those two strategies significantly lagged the other hedge fund strategies in 2009. So there were significant returns to active strategy allocation/weightings for investors in hedge funds in both years, though the positively contributing strategies were not consistent through time.

This year, given the dispersion of hedge fund returns within strategies, and with a fair amount of funds with losses as well as funds with profits within each strategy, fund of funds relative returns will be impacted much more by manager selection within each strategy silo than we have seen for a while. Strategy allocation will still have a part to play, but the 2010 ranking of returns from funds of funds will be about old style returns - driven from the bottom up.     

Of course all funds of funds claim that manager selection is a key skill. It will be interesting to see if those managers that make a special play of their abilities at manager selection in their client presentations come through with top ranking returns in 2010.


  1. Stuart MacDonald31 August 2010 at 17:00

    One of the clearest depictions of this that I have read. Keep up the good work...

  2. The depiction of manager return dispersion appears to be simply the 'worst manager' return and the 'best manager' return in each strategy. The picture would be enhanced if it were to show for each strategy the mean return and its +/- 1 standard deviation, assuming a normal distribution. That way, one could see the bulk of the returns from managers in the strategy and the outliers would be removed.

  3. Simon Kerr responds: I agree that it would be better if a distribution of returns were available for each strategy. As it is, I had such a distribution available for returns for the first half of the year but not thereafter. Capturing what is a typical return, or what an investor in hedge funds have a good chance of receiving in returns, is the aim, thereby, to an extent, capturing what the industry has delivered.
    The distribution of returns by strategy at the half way point of the year would still give a very good chance for range of the end of July returns (grouped by strategy) to straddle the zero return point. So although I agree that a richer return distribution would be a better reflection of the outcomes, I think the major point about the challenges to funds of funds in 2010 is still valid.