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 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.
|Correlation Coefficient |
Jan-1990 to Sep-2013
|HFRI Equity Hedge (Total) Index||HFRI EH- Equity Market Neutral Index||HFRI EH- Short Bias Index|
|HFRI Equity Hedge |
|1|| || |
|HFRI EH- Equity Market Neutral Index||0.50||1|| |
|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.