Hedge Fund Returns Are Path Dependent - As 2011 Illustrates

One of the things that is attempted on this website is to look at market action to help explain, or comprehend hedge fund returns. For example, two years ago a commentary was distributed on the significance of the quality factor in explaining returns in 2009 (see this article), and the impact of high correlation this year was explored  (here) too. This year has been a very unusual year in the macro background and in how markets have moved - year three of a recovery does not normally look like this one in economics or markets. 

The market events of this year have been a slalom course for hedge fund managers to negotiate (risk on/risk off), and the hedge fund indices reflect that. The HFRX Global Hedge Fund Index was down 8.58% for the year up to Monday (the 5th of December), and directional funds have fared a lot worse than non-directional strategies (the former are down 18% on an index basis).

Manager letters can be a good source of market context for hedge fund returns. In particular managers taking a quantitative approach are risk aware by nature and typically have a numerically stronger way of expressing the market conditions, and the suitability of their own methodology for extracting value from them.The overview reproduced below comes from Quant Asset Management of Singapore, managers of a portfolio of global equities.

Dear Investor,

It is unusual for us to add any written text to our monthly email other than the standard text in the newsletter. Since we apply a consistent, systematic investment methodology, once familiar with the methodology, the newsletter is normally self-explanatory. But because we are currently witnessing the biggest draw-down since the inception of the QAM Global Equities fund, 71/2 years ago, we’d like to use this opportunity to share some of our thoughts on this.

We now had a period of seven consecutive negative months with the fund being down 22% for the year. The main reasons for the negative performance are:

1) We use mostly fundamental factors when selecting our stocks from a global universe of over 6000 stocks. Fundamentals haven’t been driving markets in the past seven months. Macro-economic factors were driving markets and correlations have been at an all time high.

2) We use a trend following methodology that adjust factor weightings each period for what worked well in a certain past period (dynamic) before. This didn’t work well in the past seven months due to volatility spikes and trend reversals.

3) We use a hedging methodology whereby we are either 0% or 50% net exposed mostly based on aggregate earnings revisions number and some price performance related techniques. This hasn’t added value in the past seven months.

So the question arises if our methodology is still valid and when will it work again?          

First of all; all good investment methodologies go through periods where they struggle but as long as they add value over time and make logical sense, it makes sense to stick with them in order to achieve above average returns.

Furthermore we believe that systematically picking a large number of stocks on the basis of fundamentals (valuations, earnings growth and earnings revisions) combined with a factor adaption methodology, whilst hedging out a large part of the market risk, does add lots of value. Remember that the fund is up 154% since inception. This compares to 16% for the MSCI World in the same period.

We have always allowed volatility in our funds (around 20%, which is much more than most of our peers) in order to achieve higher returns than our peers. These high returns have been achieved and we have a strong belief that they can be achieved again. In order for this to happen one has to allow certain periods of under-performance. Draw downs are pretty natural and frequent in fundamental factor adaptation systems and one should be reminded that they can create opportunities too.

Kind regards,
The QAM Team

The letter is reproduced here to give some insight to market drivers of return this year, not to point fingers at a style or a particular manager. The general point is that the vast majority of managers take a specific approach to markets that they hope works most of the time and for most market conditions. The marketing conceit of an "all weather" hedge fund or strategy died in 2008. The returns delivered by a manager are a function of their own style and the opportunity set available from the market over the period. It is very striking  that the gyrations of markets in 2010 and 2011 made it very difficult for equity hedge fund managers to make positive absolute returns except when the equity market letter was written by the Fed and other central banks through the mechanism of QE2 (from August 2010 to March 2011). 

Hedge fund returns are path dependent, not independent of the direction of markets, nor independent of changes to intra-market or inter-market correlation, nor unaffected by the extent to which markets trend. The specific sequence of ups and downs, step-wise shifts in volatility, and how long a market regime lasts impacts the ability of the manager to harvest alpha in the way they are set up to address markets. So, for example, it would not just be relevant that markets were down 5% over a six month period, but in understanding outcomes it is more relevant that they appreciated by 11% over six weeks before losing 15-16% over 4 months (with specific volatility and correlation conditions). 

It is up to the investor in hedge funds to put together portfolios of funds which take account of the various market conditions which may occur, in full knowledge of the manager style. Building such an efficient portfolio of funds can only be achieved when investors truly understand how their capital is being applied to markets by their managers. Provided the managers stick to their expressed style, there should be a limited number of surprises to investors in hedge funds given market conditions, and how market conditions change (the specific path markets follow). For any given market conditions and sequences the better investors in hedge funds will have a range of expected return per manager in which they are invested. As yet, the path dependency of hedge fund returns is not sufficiently well appreciated  - spread the word.



UCITS III Footnote - the offshore fund from QAM was down 23.49% over the period end Feb 2011 to the end of November. The onshore equivalent  - Quant Global Equities fund, a sub-fund of the Quant AM SICAV (a UCITS III type fund) - was down  27.77% over the same period. The onshore version launched in March this year.

Quality Factors in Equity Hedge Fund Returns This Year

In 2008 one of the disappointments was the returns of market-neutral quantitatively-driven equity strategies. The difficulties were focused as much as anything else in the seemingly illogical behaviour of quality factors last year. I recently inquired to a senior researcher in equity quant about factor returns this year, and again quality factors have driven returns in unexpected ways. The behaviour of quality factors helps to explain equity hedge fund returns across different styles this year, and so I have included the following abstract from the research of this quant published at the beginning of this month:

Overview

Discerning the direction of the Quality trade remains the key issue for investors. Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Market Commentary

It has been a tough year for Quality. And it has been a tough year for stock picking. And these two facts are not unrelated. Indeed, over the past 9 to 10 months, the key to successful stock picking has been to understand the direction of the Quality trade.


The big news in the quantitative factor space, and really the market as whole, this month has been the underperformance of High Quality stocks relative to Low Quality Stocks. For the month, we saw High Quality stocks underperform Low Quality stocks by approximately 2.9%. For our quality index, this is a big move since, in general, our quality index runs at approximately 1/3rd the volatility of the Russell 1000. In other words, if our quality index were scaled to have the same volatility as the Russell 1000 index, we would have seen an approximately 8.5% down move in our Quality index this month. Clearly something is happening.


Backing up for a second: as most people are aware, the rally in the market that started around mid-to-late-July coincided with a very strong move upwards by low quality stocks. Specifically, we saw low quality names outperform high quality names by approximately 5.2%. Whereas the low quality junk rally in March was primarily focused around companies with distressed balance sheet and low stock prices, the July rally was much more broadly focused. Here we saw low quality companies of all stripes outperform. Companies with poor historical profitability outperformed. Companies with low quality of earnings (i.e. non-repeatable earnings) outperformed companies with high quality of earnings. And companies with low quality balance sheets outperformed those with high quality balance sheets. In short, the late summer rally was coincident with low quality stocks of all stripes outperforming.


Since that time, we have seen a reversal in quality and then this month a subsequent continuation of the low quality trend.


Now this stopped around September 16th as we headed into earnings season. From there to the end of October we saw High Quality outperform Low Quality stocks by approximately 4.5% as investors positioned their portfolio defensively and braced for what by all respects they feared would be a tough earnings season. Note, again these are large moves, if scaled to equivalent Russell 1000 vol, this would be a 13.5% move in a month and half.


This turned around again on October 28th, with another strong low quality rally emerging coincident with strong earnings announcements by banks, basic materials and commodity producers, consumer goods companies and REITs – in short, bellwether companies for any weakness in the recovery. As these decidedly good earnings numbers provided assurance of the recovery's continuation, investors took off defensive positions and piled back into the early stage cyclical recovery trade names. This trend has continued virtually unabated ever since, with the Quality index experiencing positive returns on only 6 of the 20 trading days last month (November). Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.


Perhaps the most surprising element to us was that the quality index has continued its downward march late last week even on the news coming out of Dubai, which instilled some measure of fear in the market. We would have expected a flight to quality on Friday as the story broke and world equity markets lurched down. But it didn't happen. Our Quality index continued to inch downward on Friday (-4 bps) and then again on Monday (-23 bps), as even geopolitical fears did not send investors fleeing to safety.


As we head into year-end, the pressing question is: do we anticipate a rally in Quality? Absent a high-impact geopolitical event, we see two scenarios under which the Quality rally can end. Namely, investors can become concerned about slowing growth and thereby move into a more defensive posture in their portfolios.


We believe the most likely cause of a pull-back in Quality is the likelihood that investors take money off the table from the strategy as valuation of low Quality stocks is no longer compelling. By most metrics that we use to judge, low quality stocks appear to be fairly to slightly richly priced.