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 the track?
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
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.