introduction
We have analyzed dozens of private and non-private market investment strategies resembling merger arbitrage and personal equity over the past few years and have identified a standard theme. Most of the products described in greater than 300 research papers simply offer access to the stock market in a sophisticated package. At low tide, risk exposure is similar in every single place.
We can show this phenomenon in alternative ways. The commonest approach is to easily perform an element exposure evaluation. Investment products marketed as offering uncorrelated returns often have high betas to the stock market, indicating an absence of diversification advantages.
But there’s an excellent simpler and maybe more powerful approach to illustrate this point: through the use of a mixture of the S&P 500 and money to copy the historical performance of an investment product with the identical level of risk.
We recently created it time Machinea freely accessible tool that permits investors to copy the performance of any mutual fund, exchange traded fund (ETF) or U.S. stock using only the S&P 500 and money.
To show Time Machine’s social media capabilities, we analyzed the iMGP DBi Hedge Strategy ETF (DBEH), which tracks the highest 40 long positions–Short equity hedge funds and located that an 81% allocation to the S&P 500 and a 19% allocation to money would have delivered nearly the identical performance with the identical volatility.
Replicating a long-short hedge fund ETF using the S&P 500 and money
Source: Finominal
In our view, these Time Machine results called into query the utility of this ETF. However, one respected Twitter commentator responded that the fund’s three-year track record was too short to attract any conclusions and that our replication process was based solely on hindsight. These were valid arguments, which is why we expanded our evaluation.
Long-short performance of equity hedge funds
Because the goal is to copy equity-like returns with lower risk, exactly what an S&P 500 plus money portfolio provides, we use long-short equity hedge funds as case studies. To evaluate the person indices, we chosen indices which have a protracted history across multiple market cycles. The Eurekahedge Long Short Equities Hedge Fund Index and HFRX Equity Hedge Index each have 20 years of history, which ought to be enough.
But Eurekahedge has a CAGR of 8.1% versus 2.0% for HFRX. Given that each aggregate the returns of individual long-short equity hedge funds, such a big discrepancy is alarming and makes it difficult to guage the attractiveness of every strategy. Which one is healthier?
Of course, the variety of funds in each index varies, but the important thing factor could also be that Eurekahedge allows recent fund managers to import their previous track records as soon as they begin reporting. Since only fund managers with good past performance apply for inclusion in these indices, there could also be a sort of survivorship bias. So capital allocators can be clever to disregard the Eurekahedge index and give attention to the more realistic HFRX, as we do in the remainder of our evaluation.
Long-term performance of long-short equity hedge funds
Source: Finominal
Long-short hedge fund replication
HFRX Equity Hedge Index volatility was 6.1% from 2003 to 2023, which we could have replicated with an allocation of 52% to the S&P 500 and 49% to money. But the CAGR of the replication portfolio would have been 3.7%, in comparison with 2.0% for the hedge funds, and the drawdown would have decreased from 31% to 19%. This results in significantly higher risk-adjusted returns for the replication portfolio.
Of course, S&P 500 investors don’t must conduct due diligence, whereas hedge fund evaluation is a costly process that requires initial assessment in addition to ongoing monitoring. In addition, there are virtually no costs for an S&P 500 ETF today, while hedge funds have high management and performance fees. So who would not prefer the replication portfolio?
Replicating the HFRX Equity Hedge Index with S&P 500 and money
Source: Finominal
More thoughts
Although a straightforward S&P 500 and money portfolio would have produced higher absolute and risk-adjusted returns than long-short equity hedge funds, perhaps our evaluation continues to be based on hindsight and has little relevance to expected returns?
Yes, but given the 0.71 correlation between the HFRX Equity Hedge Index and the S&P 500, there is no such thing as a doubt that long-short equity hedge funds provide diluted equity exposure.
Furthermore, the upside beta of the HFRX index to the S&P 500 was 0.16, in comparison with 0.25 on the downside. Therefore, equity hedge funds usually tend to follow declining stocks than rising ones. Obviously, this ratio is similar for any combination of S&P 500 and money.
At some point, hindsight turns into foresight.
Further insights from Nicolas Rabener and the Finominal Team, enroll for her Research reports.
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Photo credit: ©Getty Images / Ryan Djakovic
