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Friday 27 April 2012

Hedge Fund Performance (5 years to end-March 2012)

In this research presentation, FPM Advisers serve to evaluate and share findings about hedge fund performance for the five years to end-March 2012. Investors believe it is a significant window to assess medium-term performance of hedge funds through this unique business cycle. Further we suggest that the significance of the last 5 years is in its forecasting ability for the next medium-term outlook.

From studies of business and market cycles after a housing and financial bubble, the current cycle which ensued in 2007 as a de-leveraging turning point is expected to have enduring effects, perhaps into 2017 (See Reinhart and Rogoff reference in FPM’s last blog: Head- and Tail-Winds in 2012) .
Briefly, some fundamentals suggest more de-leveraging and economic pain is necessary. Not least from over-grown national debt burdens in some developed nations, where debt to GDP is near or over the 90% unsustainable level. A level identified by the above cited economists Reinhart and Rogoff. FPM’s long-memory serves to remind us that in-vogue Spain entered the credit crisis with 40% debt to GDP, while now it is greater than 60%. Also confounding, is that the UK entered the crisis with debts at 94% of GDP! FPM understands the other forces at play, such as the question of fiscal and monetary integration in the European Union…

FPM Hedge Fund Risk-Performance Analysis

We present the risk-performance analysis of all 32 HFRI Hedge Fund Indices and the S&P 500 market proxy, during the past 5 years. Our last comprehensive analysis of all HFRI hedge fund indices was for the four years to June 2011 – see Hedge Fund Performance Since July 2007.

The colour highlights in Table 1 below displays the outliers and median statistics comparing all hedge fund and market benchmarks. The colours highlight the best, worst and median performances for a given metric (green, yellow and cyan respectively). This graphic visual helps to select from the mix of strategies and their corresponding statistics. This tool towards fund portfolio management we call “FPM Performance Comparison Tool” or “FPM PCT”.
 Table 1 Click on Image to View in Full Screen

The hedge fund indices presented in the table are sorted in descending order of Sharpe ratio performance. Top of the table is a Sharpe ratio performance of 1.47 (highlighted green) from Relative Value – Fixed Income Asset Backed strategies. (In September 2011 FPM investigated and introduced this stellar performance strategy in its research entitled Credit Markets @ Workout Inflexion Point.) At the bottom of the table is the FOF - Conservative Index, producing a negative Sharpe of -0.43, highlighted yellow. 

While the allocation decision is a complex one our FPM tools certainly makes it a simpler. Given an investor’s risk-reward preference, the rear-view mirror of performance can suggest performance expectations of strategies in given market conditions, ceteris paribus. Or else the FPM table is used to compare a customised portfolio’s performance over the same horizon.

Conservative Portfolio Allocation Considerations

A hedge fund allocator running a conservative portfolio for a treasury or chief investment office, may select low volatility investment strategies aiming to preserve capital – and by implication selecting funds exhibiting such characteristics.

Over the past 5-years an Event Driven - Merger Arbitrage strategy produced the lowest annual volatility of only 3.5%, with the median annualised volatility being 8.3%. A ‘median vol’ investment fund with diversification benefits can be sourced from the Fund of Funds – Strategic class. Similar median low risk returns were demonstrated over the 5 years by Event Driven - Distressed/Restructuring and Relative Value - Fixed Income-Corporate buckets. So a positive selection based on volatility alone suggests 5 different sub-strategies of hedge funds to choose from. Ignoring aggregated indices, the top 5 least risky sub-strategies are shown below:

Top 5 Low Volatility Hedge Fund  Strategies (over Apr’07 to Mar’12)

Hedge Fund Sub-Strategy
Annualised  Volatility
ED: Merger Arbitrage Index
EH: Equity Market Neutral Index
RV: Fixed Income-Asset Backed
FOF: Conservative Index
ED: Private Issue/Regulation D Index

Also, perhaps there are other strategies to avoid or de-select in aiming to minimise volatility: such as Emerging Markets - Total strategies, which exhibited a high 14.7% annualised volatility over the said period. This is almost as twice as much as a median volatility strategy such as ED - Distressed/Restructuring, RV - Fixed Income-Corporate Index or FOF - Strategic Index.
We suggested ‘perhaps’ avoid Emerging Markets strategies because in fact adding the appropriate marginal weighting of a sub-strategy could be marginally incremental to absolute returns than additional risk for the said conservative portfolio. For instance, including an Emerging Markets - Asia ex-Japan strategy, with a positive Sharpe ratio of 0.13, would be a net risk-return benefit. Over the past 5 years, 0.14 is the median Sharpe ratio of all hedge funds performance.
Other strategies unsuitable for the CIO / Treasury portfolio may be the Equity Hedge - Sector (Energy/Basic Materials) Index, exhibiting 18% annualised volatility, the third riskiest sub-strategy in a mean-variance framework.

Attention Reader: Please understand that analysing indices is a similar process to evaluating the underlying or representative funds, i.e. unifying top-down and bottom-up analysis in hedge fund allocation decisions.

Important to recognise that analysing benchmarks is in effect studying averages. So imagine the complexity of the risk-return variations in the underlying hedge funds, in spite of the caveats of mean-variance framework.

* An updated version of FPM Hedge Fund Risk-Performance table using the third and final revision from HFR databases is available upon request when HFR Research Inc publishes final revision for March on May 1st, 2012.

Macro Strategy Focus

In this paradigm of fundamental shifts in macro variables of global economies, our first and foremost recommendation for inclusion in a fund portfolio is a global macro hedge fund strategy. Chart 1 below shows the ‘stalwart performance’ persistence of the macro benchmark during this fundamental economic shift paradigm.  

                                Chart 1: Click on Image to View in Full Screen

FPM’s lead series of hedge fund managers who typically employ a global macro strategy, known as the “Commodities Corporation Offspring”, are Tudor Investment Corp (Paul Tudor Jones), Moore Capital (Louis Bacon) and  Caxton Associates (Bruce Kovner).
Despite the unspectacular 2011 performance of these three managers, as reported via Reuters in Most Global Macro Hedge Funds Suffer, Brevan Howard Thrives, we believe in the swings-and-roundabout performance of these leading lights. Of the top London-based global macro managers, there is at quick-pick Brevan Howard (Alan Howard) and Balestra Capital (James Melcher).

Of the two main styles global macro trading, discretionary and systematic, both styles had a difficult year in 2011. Witness Tudor, Caxton and Moore who tend towards discretionary. FPM Excel level screen dump below shows that the systematic style had the ‘Worst Drawdown % (& Period)’ of -6% between May and June of 2011.

                               Screen Dump 1: Click on Image to View in Full Screen
To the author this is somewhat revealing and indicative that the systematic models and algorithms which endured the peak of the credit crisis crash produced the worst drawdown in its aftermath! Since these global macro traders digest fundamental and technical data, the difficulty in generating performance suggest there’s likely to be a prolonged and incongruous flux between economic and market conditions.  Or as Simon Kerr, an independent investment consultant succinctly considers this dichotomy in his recent blog: “…If the fundamentals are still in gear with the original trade idea, and the outcomes are being driven for the reasons looked for then the trader will concentrate on the technical position”.

As FPM noted at the beginning of this note, about ‘this unique business cycle’, we believe their predictive powers encapsulated in the last 60 months of hedge fund strategy performance. Further that the regulatory and Fed-watching for policies, whether real or rhetoric dressing, and their outcome is crucial to economic and market comprehension by traders and investors. As if on cue for this article, just as much as double-dip was augured, and as FPM like to say “Stop Press!”: UK economy in double-dip recession!”

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