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Sunday 19 December 2010

Hedge Fund Performance Through Credit Crisis

Hedge Fund Performance Analysis:

> Time is circa 3 years since the onset of the US-housing led global recession. A timely look at hedge fund performance justifies with caution the new asset class.

> Using data from the leading hedge fund index provider and Fund Portfolio Management (FPM) analysis, the HFRI Fund Weighted Composite Index gained 5% versus the S&P 500 loss of 20%, over the three years ending November 2010.

> The best performing hedge fund strategy (as highlighted by FPM's many "Green for Go" in the above Perfomance table) are Macro hedge fund strategies: returning the best compound return of 15% against other hedge fund strategies and market benchmarks, over the said period. Notice that macro funds were the leading performance in terms of 10 of the 12 analytical metrics. FPM’s sub-sectoral analysis reveals that the “Macro: Systematic Diversified Index” returned 23%, contributing to overall macro strategy outperformance (sub-sectoral analysis not shown in table - available on request only).  

>FPM’s analysis highlights in yellow the worst performances per analytical metric in the considered set of investments. Indeed “Yellow Alerts” galore for the Market Index – S&P 500; including worst drawdown / loss of 17% in October 2008 (not visible in table), time of Lehman bankruptcy. The broader FPM Level II shows that “Emerging Markets: Russia/Eastern Europe Index” was the poorest performer with 6 out 12 lowest metrics of entire hedge fund indices and S&P 500.

> Careful conclusions drawn from the performance of the asset classes (i.e. between bellwether US equities and alternative asset hedge funds) shows that hedge funds overall preserved capital, which is one their raison d'etre. Additionally, that hedge fund’s premise of dynamic asset allocation is best exemplified by macro strategies over the long-term.

> Notable is the -9% loss in the fund of hedge funds (FoHFs) sector, as displayed by the Fund of Funds Composite Index. In context, this performance is still more than 50% better than being invested in long US equities. The FoHFs loss does raise concerns about the business model’s benefits (especially if considered in a parochial absolute performance context).

>  Some investors may find it a surprising that emerging markets strategies produced lower volatility than the developed market equity benchmark the S&P 500 (16% and 22% annualised standard deviation). FPM understands that the risk-focus of the hedge fund model contributes to this lower volatility. That said, the volatility metric of emerging markets is also the highest when compared just to other hedge funds. FPM believes volatility is indeed a characteristic of general emerging market investments.

> As highlighted by “Yellow Alerts” the emerging market index suffered the worst drawdown of all the strategies over the 3 years to end November 2010. Drawdown, which is defined as consecutive months of negative returns in the investment / index, was a dismal -45%. What is not visible on performance table (only FPM’s Excel-based comments shows the drawdown periods), is that this run of negative monthly returns from emerging market focused funds occurred between June 2008 and February 2009; a notably heightened period of systemic market stress, encompassing massive subprime related write-downs and Lehman’s demise.

> Only a few considerations of hedge fund analysis were observed using the above longer-term 3-year window of performance (December 2007 to end-November 2010). Hedge funds performance viewed over the last 2 years (as in performance table below) shows some differences, what a difference a year makes! as recessionary fear abates and the credit-led crisis works out.

> Notable that Relative Value index shows more “Green for Go” metrics: for example, with Sharpe ratio of 3.89 the sector demonstrates the best return per unit of risk (volatility / standard deviation). Macro strategies, which over 3-years looked like the best performing strategy, but over this 2-years window now looks relatively lacklustre, especially with 0.66 sharpe ratio. Suggesting volatility in all investments asset classes and difficulty in tactical asset allocation.

> FPM’s Excel comment (not visible in above 2-years performance table) indicates that Relative Value strategies had their peak performance over 16 month period (between January 2009 and April 2010), where consecutive positive index returns produced a staggering  28% outpacing the Macro index showing of just +4% over the same period.
Additionally, the best sub-sectoral strategy within the total relative value universe was asset-backed fixed income.

> Complexity of constructing a hedge fund portfolio is even more entangled if one looks at the last 12 month to end-November 2010 performance, as shown in table below. 

> In the past year of modest global economic recovery and debt work-out for the credit-weaned businesses and individuals, the relative value sector seems the best strategy for selection. The strategy includes credit-focused hedge funds in asset –backed securites and convertible bonds (Click HFRI Indices Classifications to see what comprises the Total Indices).

> Comparisons of FPM’s performance metrics using HFRI indices (or even individual hedge fund NAVs) facilitate tactical asset allocation through observations in quantitative terms of hedge funds. FPM’s author, has aimed to provide basic qualitative observations from the performance table.

> Hedge funds as an asset class has not widely been embraced by investors (compared to say ETFs). FPM believe hedge funds are here to stay and that they will eventually converge with mutual funds, with inevitable issues to be ironed out of infant industry in institutional stages.  Yet this crisis (as previously with the 2000 technology bubble), has shown that active management and investment technology combine well for riding out difficult markets ie ones without clear secular long-trend rallies.

FPM endeavours to educate and convey aspects of hedge fund investments.
Please contact FPM’s editor Kristian Siva (ksiva@talktalk.net) for further information.

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