This is one of many questions I’ve been asked by advisors recently as hedge funds and liquid alternatives continue to muddle through this low return, range bound market. In fact, many hedge fund managers have openly expressed a low appetite for risk-taking in this market environment and indeed appear to be operating at very low levels of volatility (see chart below). As an example, Multi-strategy hedge funds, a good proxy for a diverse set of trading strategies, have lower volatility than the broader bond market over the past three years. Given the long list of concerns cited by managers, including the late stage of the bull market, negative real interest rates and decelerating world growth, this makes sense. But, against a backdrop of easy monetary policy, many are questioning their conservative profile as unhedged stocks and bonds continue to outperform.
Does low market volatility hurt hedge fund results?
As a general rule, unhedged market betas perform best (nominal & relative) when volatility is lowest. While overall volatility levels for many strategies are low by historical standards, they are proportional given current levels of market volatility. For example, Equity Long/Short strategies typically operate between 55 and 65% of the volatility of the broader stock market. While on the lower end of that range recently, it is really the up/down capture ratio that continues to plague many of these managers. The first quarter of 2016 was a great example as long/short funds fell more than their net exposures would imply and didn’t participate proportionately in the ensuing rally. While all skill-based strategies can be expected to fall out of favor from time to time, the combination of a risk on/risk off environment and a sector rotation into last year’s laggards whipsawed this particular strategy after a respectable 2015.
But other strategies including Multi-strategy, Equity Market Neutral and Relative Value (Arbitrage) have fared better recently and are operating near or above their longer-term Sharpe ratios (see below). Equity Market Neutral, for example, outperformed stocks, bonds and all major hedge fund strategies in a range-bound market in 2015. While managers are running low volatility portfolios, their Sharpe ratios would imply they haven’t lost skill. By comparison, the trailing 3 year Sharpe ratio on unhedged stocks and bonds are unusually high, suggesting the strong potential for mean reversion as volatility inevitably rises.
What’s on the horizon?
Circling back to the original question, ‘are hedge funds too conservative?’, you have to consider what may lie ahead. Managers are clearly worried about the recent decoupling of earnings from stock prices, decelerating world growth and negative real interest rates. And, as the timeline chart below demonstrates, the Sharpe ratio on both stocks and bonds are well above their long-term averages. More important, the process of mean reversion may have already started for stocks as Sharpe ratios have fallen from a level of over 2.00 in May of last year, a level not seen since the late 1990s.
But history has told us that markets can overshoot for extended periods and this Fed-fueled market appears to be no exception. The question, therefore, is not whether hedge fund managers were too early in expecting a market reversal – they clearly were. The more important question is whether they will eventually be proven right.
Source: Data from Morningstar, Hedge Fund Research. (www.hedgefundresearch.com) © 2016 Hedge Fund Research, Inc. – All rights reserved and BarclayHedge. Sharpe ratios in chart are based on rolling three year periods between June 1991 and June 2016 and use the 3 mo. T-Bill as the risk-free rate. Stocks and bonds are based on the S&P 500 Index and Barclays Aggregate Bond index respectively. Equity Long/Short, Market Neutral, Relative Value and Macro are based on the HFRI Equity Hedge, Equity Market Neutral Relative Value and Macro indexes respectively. Multi-strategy is based on the BarclayHedge Multi-strategy index *inception January 1997.