By Tom Williams
Interesting people and the things they do often
garner attention from the crowd. But history tells us that
although the opinions of the loudest spectators can become
conventional wisdom, they may be rife with misunderstanding.
Georgia O’Keefe painted beautiful works of art but
had to fight back against a Freudian interpretation of her
flowers (anatomically, by the way, the middle of a flower is
genderless…). Some saw an untitled bright yellow and red
painting by Rothko as the expression of a sunny outlook. He
insisted it was tragedy, and one day committed suicide. In art, the audience might see
what they want to see, and not the underlying reality.
For hedge funds, there is no denying, the industry
has a certain cachet, a je ne sais quios. They appear in the
news and in commentaries and we often see statements and
opinions that are curious and confusing to us. Hedge fund
managers usually just want to do their jobs and focus on their
investments, but the audience wants something else.
Take for example, a joyous headline proclaiming
that hedge funds failed to outperform the S&P 500 for the
month, year, etc. While our firm’s natural habitat
is somewhere far from the more aggressive part of the hedge
fund universe, I have rarely come across a hedge fund whose
stated goal is to beat the S&P 500. Equity-like returns,
yes, but almost always, with less risk.
This is a key part of the hedge fund equation. Just
for fun, we recently did a Google news search for articles with
the search phrase, "'hedge fund’ returns 'S&P
500’". There were 13,200 results. We changed
'returns’ to 'risk-adjusted returns’
and got back 4 results. So for every 13,204 authors, four are
thinking about risk and 13,200 are thinking only about returns.
Could it be that those 13,200 authors have never heard of
risk-adjusted returns, or the Sharpe ratio, or became curious
when they noticed the different payouts for different horses at
It’s more likely that the authors
believe that audiences want to hear about hedge funds failures,
blow-ups as well as outliers providing outsized returns.
That’s interesting. The idea of hedge funds
consistently generating high risk-adjusted returns over a cycle
– not so interesting.
It’s also curious that people talk
about hedge funds as if it were one asset class. An
asset class is a group of investments that behave similarly
in different market conditions. Stocks, bonds and cash are the
major asset classes at the most basic level. How do we explain
that while many hedge funds have some positive correlation with
each other, they are not homogenous, and it is very imprecise
to group them as one asset class?
For example, I think we would all agree that growth
stocks and value stocks are fairly classified as being in the
same asset class (equities). Excluding the tech bubble, the
correlation of these stocks is 0.93 from 1979. If we look at
different equity-related hedge fund strategies, the
correlations are very different. A correlation matrix for the
HFR Equity Hedge, Equity Market Neutral, and Equity Short Bias
indices is below.
Jan-1990 to Sep-2013
|HFRI Equity Hedge (Total) Index
||HFRI EH- Equity Market Neutral Index
||HFRI EH- Short Bias Index
|HFRI Equity Hedge
|HFRI EH- Equity
Market Neutral Index
|HFRI EH- Short
We believe that talking about "hedge fund returns"
doesn’t tell you very much because of the
diversity of the strategies. The analysis of hedge funds needs
to be done at a more granular level to develop more realistic
expectations from these investments. On a basic level,
investors should consider how much exposure funds have to
different markets, as well as the funds’ leverage,
liquidity and concentration. Judging an activist fund long a
handful of stocks with the same yardstick as a fund buying
non-agency mortgages or a fund doing convertible arbitrage
makes no sense.
This may be too complicated or time consuming for
many investors, but that doesn’t mean we should
give up on educating them. Succumbing to the tantalizing
headlines is tempting. The voice of the crowd is commanding.
But to see the underlying reality requires more.
Thomas Williams is a managing member,
chief investment officer and head of investments at Pine Grove
Asset Management, an SEC registered investment adviser
headquartered in Summit, New Jersey.