Hedge funds steady through market turmoil

2008 was a watershed year for the investment community as performance and risk management strategies based on historical correlation models were both found wanting. Asset price correlation spiked, eliminating the diversification benefits of traditional p

Research by Momentum Alternative Investments using objective data and historical performance information demonstrates hedge funds can and do preserve capital during periods of market stress and adding them to traditional portfolios offers investors significant benefits. The research indicates appropriate hedge fund selection increases a balanced portfolio’s risk-adjusted returns.

“A skilled investor could have generated positive, mid-teen returns on their diversified domestic hedge fund portfolios during the worst of the 2008 market slump,” says John Caulfield, chief investment officer at the Momentum Alternative Investments fund-of-fund business. “The average return for fixed income arbitrage (FI), equity market neutral (EQMN) and equity long short (EQLS) hedge fund strategies in 2008 was +14.30%, +11.13% and +2.06% respectively, compared to -26.24% for the JSE sectors.”

Hedge fund managers have an expanded opportunity set relative to traditional long-only portfolio managers as a result of their unconstrained mandates. They are able to take long and short security positions by using a range of investment strategies meaning, if positioned correctly, they can profit from both rising and falling markets. The pool of investable securities is also greater and thus a further means of generating absolute returns.

To test the assertion that hedge funds can protect capital, Momentum Alternative Investments investigated the year-to-date (YTD) returns for the local industry in 2008. The period was characterised by extreme uncertainty and volatility and has been compared to the Great Depression in terms of drawdown severity.

“The research involved the three major South African hedge fund strategies, determined by assets under management, specifically EQLS, EQMN and FI,” adds Caulfield. “To provide fair illustration of the performance of the South African hedge fund industry, the full spectrum of 2008 returns for the larger managers in each category were included.”

The 2008 performance of seven FTSE/JSE investable indices was also included for comparative purposes (the FTSE/JSE ALSI, FINI15, INDI25, RESI20, Small-Caps, Top-40 and Mid-Caps). Figure 1 provides graphical representation of these returns and table 1, a summary of the 2008 dispersion statistics.

What is evident from the chart and table is hedge funds preserve capital (the average return for each hedge fund strategy was positive in 2008, which was not the case with JSE sectors). Furthermore, volatility in the markets caused wide dispersion of returns within hedge fund strategies; the difference between the best and worst EQLS returns was spread between -25% and + 31%, illustrating how hedge funds within the same strategy can still have very different underlying positions. In other words, it was possible to generate positive returns but skilled manager selection was a crucial component of doing so.

We extended the stress testing to between August 2007 and January 2012 to check whether the same results were achievable over a longer period. The period is an interesting one in that it incorporates a number of very different investment environments, including bull and bear markets, as well as periods of high and low volatility. Stress testing is an evaluation methodology that focuses attention on negative monthly returns for traditional asset classes, namely equities and government bonds, and then compares these returns to the corresponding hedge fund return.

As a benchmark for hedge fund performance over this period, Momentum Alternative Investments constructed three equally-weighted indices using monthly hedge fund returns obtained from HedgeNews Africa. The first, named Hedge Fund Composite Index (HFCI) was a composite including all the funds from the three underlying strategies. The second included only managers employing EQLS strategies and the third, named Fixed Income Arbitrage Index (FI HFI) encompassed those managers trading only relative value in the fixed income markets.

Comparing the FTSE/JSE All Share Index (JSE ALSI) to the Equity Long Short Hedge Fund Index (EQLS HFI) for the period gave the following results:

Table 2 gives a summary of the statistics; of the 24 negative months on the JSE ALSI, 13 were positive for the EQLS HFI. While the worst month and the maximum drawdown for the JSE ALSI was -13.24% and -40.44% respectively, the corresponding returns for EQLS HFI were -3.91% and -6.10%. The EQLS hedge funds showed lower losses and improved risk statistics compared to the JSE ALSI over the period. These results clearly show the value hedge funds bring to traditional asset portfolios through their diversified return streams and ability to preserve capital.

“The last five years have shown traditional South African asset allocation and portfolio construction frameworks may be obsolete or, at best, ill-suited to the challenging macroeconomic environment investors currently face,” concludes Caulfield. “Skilled hedge fund selection can increase returns whilst simultaneously reducing risk in a traditional portfolio, as is evidenced by the hedge fund performance in our research.”

For further information on the study, please go to:

http://www.momentuminv.co.za/Libraries/Alternative_Investments_Hedge_Funds/Hedge_Fund_Study_-_May_2012_Updated.sflb.ashx