We have analyzed dozens of public and private market investment strategies, such as merger and private equity arbitrage, respectively, over the past few years, and one common theme has emerged. Most of the products described in more than 300 research papers simply provide exposure to the stock market in complex wrappers. Once the tide is out, exposure to risk is the same everywhere.
We can prove this phenomenon in different ways. The most common technique is to simply perform a factor exposure analysis. Investment products marketed as offering uncorrelated, high returns are often shown to be experimental to the stock market, highlighting the lack of diversification benefits.
But there is a simpler and perhaps more powerful way to make the point: by using a combination of the S&P 500 and cash to replicate the historical performance of an investment product with the same level of risk.
We recently created Time Machine, a freely accessible tool with which investors can replicate the performance of any mutual fund, exchange-traded fund (ETF), or US stock using only the S&P 500 and cash.
To prove the power of Time Machine in social media, we analyzed the iMGP DBi Hedge Strategy ETF (DBEH), which tracks 40 long-term leading–Short stock hedge funds, and found that an 81% allocation to the S&P 500 and a 19% allocation to cash would have done roughly the same with the same volatility.
Hedge fund repeat long – short ETF with S&P 500 and cash
From our point of view, these Time Machine results described the usefulness of this ETF into question. On the other hand, a respected commenter on Twitter responded that the fund’s track record over three years was too short to draw any conclusions and that our copying process was simply based on hindsight. These were fair points, so we expanded our analysis.
Short-term long-term hedge fund performance
Since the goal is to replicate equity-like returns with less risk, or exactly what an S&P 500 plus-cash portfolio provides, we use long-term equity hedge funds as case studies. To evaluate each, we selected indexes that have a history spanning multiple market cycles. The Eurekahedge Long-Term Equity Hedge Fund Index and the HFRX Equity Hedge Index both have 20 years of history, which should be enough.
But Eurekahedge has a compound annual growth rate of 8.1% versus 2.0% for HFRX. Given that both combine long and short hedge fund returns for individual stocks, such a large discrepancy is alarming and makes it difficult to assess the attractiveness of each strategy. Which is better?
Of course, the number of funds in each index is different, but the underlying motivation may be that Eurekahedge allows new fund managers to import their previous records once they start reporting. Since only fund managers with good past performance request inclusion in these indexes, there may be some form of survival bias. Therefore, allocators of capital would be wise to ignore the Eurekahedge index and focus, as we do in the rest of our analysis, on the more realistic HFRX.
The long-term performance of long-term short-term hedge funds
Repeat long and short hedge funds
The volatility of the HFRX stock hedge index was 6.1% over the period 2003 to 2023, which we could have replicated with an allocation of 52% to the S&P 500 and 49% to cash. But the compound annual growth rate for the replication portfolio would have been 3.7% compared to 2.0% for hedge funds, and the drawdown would have fallen from 31% to 19%. This results in significantly higher risk-adjusted returns for the copying portfolio.
Investors certainly don’t have to perform any due diligence procedures on the S&P 500, while hedge fund analysis is an expensive process that requires initial evaluation as well as ongoing monitoring. Moreover, today’s S&P 500 ETF has no expenses, while hedge funds come with high management and performance fees. So, who does not prefer a replication wallet?
HFRX Hedging Index Repeat with S&P 500 and Cash
Although a simple S&P 500 index and cash portfolio could have yielded higher absolute and risk-adjusted returns than long-term equity hedge funds, could our analysis still be based on hindsight and have 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 little doubt that long-term equity hedge funds offer dilutive exposure to equities.
Moreover, the HFRX’s beta bullish beta for the S&P 500 was 0.16 compared to 0.25 on the downside. As such, equity hedge funds track down-trend stocks more than up-trend stocks. Obviously, this ratio is on par with any S&P 500 cash pool.
At some point, hindsight becomes too late.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: © Getty Images / Ryan Djakovic
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