Thursday, October 8, 2015

Beating stocks or bonds - hedge fund performance mixed



If the stock market goes down relative to a hedge fund's performance, the hedge fund manager may say the fund was successful because it beat the equity index even if the fund generated a negative return.  Stocks go up and a hedge fund manager may say they were trying to be a bond substitute. The fund was not supposed to beat the equity market. In this competitive world where benchmark comparisons are not well established, there is a lot of switching of performance metrics.  Investors have to agree on the metrics early in the process. 2015 is already shaping up to be one of those years of changing the goalposts for hedge funds. 

So what is the right comparison? Setting benchmarks is not an easy question, but there is an issue if hedge fund managers switch back and forth based on the latest performance numbers. This may not be a fair assessment, but most investors are looking for two things. Better diversification and limited performance drag versus traditional stocks and bonds for the diversification received.

There is the belief that hedge fund investors will give up long-term return versus equities in exchange for diversification, but the return shortfall should not be greater than bonds which also offer diversification. Bonds may underperform stocks but you gain diversification and lower risk. The same framework should be applicable to hedge funds. Lower returns are acceptable if you get a strong boost of diversification. However, if you provide less diversification than bonds, you better not see a performance drag versus bonds. 

Let's look at 2015 as an example of the issue. There were four styles that beat both stocks and bonds. There were four styles that underperformed both stocks and bonds. The rest of the styles or just under 60% have shown performance between the two extremes. This may be what we should expect. Most hedge funds have betas that are less than one but are likely to have a beta that is higher than bonds.

The bracketing of performance around bonds and stocks is a nice simple way to determine what hedge funds are doing for an investor. This should then be compared with the degree of diversification. In this context, hedge fund returns are acceptable but certainly not stellar.

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