Absolute Returns? What Has Been Happening to Hedge Funds?

Damien Laker CIPM, CompoundingHappens.com

7th November 2008

"After all, about the most hollow achievement in finance is this:
to provide absolute returns—but only when markets are going up".
— The Economist, October 23rd 2008, p. 82

After all, aren't many hedge funds supposed to have long positions and short positions that offset one another's market risk, leaving only the pure magic of genius as the residual return?  And isn't there even a class of "short bias" hedge funds that are designed to make big profits in falling markets?  Shouldn't these funds have performed astoundingly as markets dropped?

Hedge fund performance (on the whole) has been disappointing in 2008.  For the period January-September 2008, the Credit Suisse/Tremont Hedge Fund Index was down 9.87%.  Two horrendous months for the industry were August (down 1.47%), and September (down 6.55% for the month).

On our Risk page, we show that there are enormous diversification benefits available from investing in a market neutral fund (one which has a nearly zero correlation with the market).  This is suppose to be the compelling benefit of hedge funds.  However, in 2008, hedge funds seem to have almost all been falling just at the same time as the market is falling. 

"Few strategies have worked well. Ken Griffin, the boss of Citadel, a fund based in Chicago and known for its quantitative techniques, told investors that September was "the single worst month, by far" in its history.  Even David Einhorn, an American short-seller who bet successfully on Lehman Brothers' demise, has lost plenty"¹.

The evidence that hedge funds are having a difficult time is not just anecdotal.  According to Credit Suisse/Tremont, the average long-short equity fund is down 13.28% for the calendar year to September 2008.  And even "dedicated short bias" funds, which one would expect to definitely make money in a down market, lost 6.08% in September 2008, and 4.50% in August 2008.

How can so many funds be losing money, regardless of whether they are long, short, or market neutral?  It doesn't really make sense.  Yet it is surely happening.

Below, we will discuss some hypotheses that attempt to explain this phenomenon.

But, for the moment, consider the possibly enormous implications for portfolio construction.  Since Harry Markowitz invented Modern Portfolio Theory, investors have known that the way to optimise the trade-off between risk and return is by considering the expected return vector and covariance matrix for all the candidate assets that one might be able to hold in a portfolio.  Assets whose returns have low correlations with one another will combine felicitously to reduce the overall portfolio risk (we show a graph of this on our Risk page).  A key point here (and Markowitz was by no means dogmatic about this) is what "risk" means.  The usually accepted interpretation of risk is that it means the standard deviation of returns.  But many scholars have also pointed out that risk could be defined as downside risk, where the crucial issue is downside fluctuations in value.  This idea is hard to ignore, because it seems entirely obvious that investors are averse to downward fluctuations in their portfolio (and don't really object to upward fluctuations).

Recent events have been a potent demonstration that the difference between symmetric risk and downside risk does matter in practice.  Or, using slightly different terminology, a portfolio that has been optimised to cope with "mild risk" may not cope so well with "wild risk".

This is all crucial when it comes to constructing a portfolio.  If alternative assets such as hedge funds are going to dive for the floor at the least convenient moment, the rationale for using them in portfolio construction becomes dramatically weaker.  Recent events have been a very loud wake-up call for investors that alternative assets can behave abnormally just at the moment when investors would most wish them to provide stability.

Diversification is not dead, but it's clear that investors should not uncritically accept the sales pitch that alternative assets will provide strong protection against market meltdowns.  Before the 1987 downturn in equities, many investors were relying on ideas such as "portfolio insurance" to protect them.  Because portfolio insurance strategies required a continuous market, they didn't work properly in a situation where markets gapped down 25%.  Similarly, the recent vogue has been to use alternative assets such as hedge funds to provide some sort of protection against very unfavourable markets.  Again, the success of this strategy has been limited.  Could it be that any widely-adopted attempt at crash protection may carry within itself the seeds of its own destruction, because when millions of investors rush for the door simultaneously, the door will inevitably get blocked? 

Perhaps the hedge fund industry will suffer a bit of a downturn after the recent fiasco.  The Economist reports that there is an historical precedent for a heavy downturn in the hedge fund business: "Between the end of 1968 and September 1970, the assets of America's top 28 hedge funds dropped by two-thirds ...".  Certainly, so far as pension funds and other long-term investors are concerned, it seems very hard to justify any allocation at all to hedge funds (especially when one takes their swingeing fees into account).  This seems to be the view taken by Warren Buffet (as we describe on our Performance Fees page).

Possible Explanations for the Recent Performance of Hedge Funds

How can one explain the recent poor performance of hedge funds?  There are many possible explanations:

• Unwinding of the carry trade: Vast amounts of money have been borrowed over the past few years in the "carry trade".  The basic strategy here is to borrow in a currency where interest rates are nearly zero (in recent years, this has been Japanese Yen (JPY) and US Dollar (USD)), then to use this (nearly) free money to speculate in asset markets.  Economists will tell you the carry trade is not a free lunch, because the cost of hedging the FX risk would (on average) cancel out the benefit of borrowing in a low interest rate currency.  However, currencies do not move in smooth lines reflecting the economic fundamentals.  Naive or risk-seeking investors can engage in the carry trade for years with being burned.  However, in the few months since mid 2008, there has been a dramatic realignment of FX rates, with the US Dollar and Japanese Yen appreciating dramatically against other currencies.  This appreciation has been driven by carry trade investors all rushing for the door at once.  Only the lucky few who rushed through the door first will have escaped without suffering big FX losses.  This phenomenon has had a self-reinforcing effect, as many years of speculation have been wiped out in a swift and turbulent market correction.

• An alternative (but similar) explanation uses one of the currently popular phrases: "de-leveraging".  In the recession of the early nineties, the same phenomenon was called "balance sheet repair".  Either way, the idea is that many banks, hedge funds, insurance companies, private investors, and other market participants were all holding substantial amounts of debt during the economic expansion.  When asset prices started collapsing, anyone who was holding debt experienced a deterioration in their debt/equity ratio.  To deal with this, they sold assets in order to repay some of their debt.  This in turn forced asset prices lower, forcing further rounds of selling, in a vicious cycle.

• Another angle on the de-leveraging theme is that clients of money managers have been withdrawing their funds at a rapid rate.  This has forced investment companies to sell large chunks of their holdings, which has forced prices down, etc.

• Yet another angle on the de-leveraging theme, especially relevant to hedge funds, is the misfortune of the large investment banks who function as prime brokers.  Prime brokers are the large firms who facilitate the operations of hedge funds, providing them with custody services and credit.  Two of the large prime brokers were Morgan Stanley and Goldman Sachs, who, as non-banks, were not subject to strict regulatory limits on the amount of debt that they held.  After the collapse of Lehman Brothers, these firms decided that they would like to be banks so they could take advantage of credit lines from the Fed and the US Treasury.  Once they became banks, they had to be more stringent in their lending to hedge funds.  BBC business editor Robert Peston explained it this way on his blog: "As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.  It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.  This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs."

• One angle that we haven't seen discussed anywhere else is the fact that so many quant strategies are -- at their heart -- actually momentum strategies.  In a momentum strategy, one tries to hold securities that are trending upwards, while shorting securities that are trending downwards.  This can be done quite consciously using a sophisticated factor model to calibrate the bets on momentum.  Or, it can be done quite inadvertently by following techniques such as betting on assets based on whether they are following trend lines on a chart.  Either way, quantitative research (for example, the research by Dimson, Marsh, and Staunton, reported here) has shown that one can normally earn excess return by betting on momentum.  Many hedge fund investment strategies ultimately rely on momentum: things that have been going up tend to keep going up, and things that have been going down tend to keep going down.  This normally reliable relationship has broken down recently, with markets swinging wildly up and down.  Reportedly, there have been very abnormal outcomes from statistical measures in markets such as cross-sectional volatility and the correlation between different assets.  This would all tend to mean that quantitative momentum strategies, the mainstay of most hedge fund managers' bets (whether they realise it or not) have ceased to work during the events of 2008.

In summary, there are many plausible explanations based on the de-leveraging theme.  They are probably all valid as part of the explanation for what has happened to markets and hedge funds during 2008. 

Then, there is also the explanation based on the recent failure of the normally reliable momentum factor.  We think this explanation also accounts for part of the phenomenon.

Teasing-apart all of the factors behind hedge fund performance in 2008 would be a very difficult job.  It would indeed be a worthwhile subject for a doctoral dissertation.

Meanwhile, the fact remains that hedge funds have turned out to be less useful than they seemed to be as portfolio diversifiers.  That, combined with high fees, should make investors think very carefully when they are determining their asset allocation.

See Also

• CompoundingHappens.com explanation of Exposure

• CompoundingHappens.com explanation of Risk

• CompoundingHappens.com explanation of  Derivatives Counter-party Risk

References

1.  See Credit Suisse/Tremont hedge fund index web site

2.  "The Incredible Shrinking Funds", The Economist, October 23rd 2008

Footnotes

1. The Economist, op. cit., p. 79.

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