Do hedge funds hedge? The experience of the Great Recession
Vanguard research
Executive summary. Do hedge funds help investors avoid the worst during periods of distress in the financial markets? The recent Great Recession provides an opportunity to explore the experience of hedge fund investors during just such a time. In this paper, we look at funds of hedge funds as well as at several categories of specific types of hedge funds. We find that hedge funds served to insulate investors to some degree from the extreme stock market crash, but that most of the hedge fund categories failed to provide significant diversification beyond that of a 60/40 portfolio of stocks and bonds.
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May 2010
Author Geetesh Bhardwaj, Ph.D.
From the equity market peak in October 2007 through the early months of 2010, investors experienced a roller-coaster ride. Their nerves were tested by the lows of March 2009, which were followed by an equally spectacular rebound in the latter part of that year. So precipitous was the fall that even after returning 56% from the end of February 2009 through the end of February 2010, the equity market was still down by 23% from the peak in October 2007.1
Over the years there has been growing interest in hedge funds as an alternative asset class, in part because of the belief that hedge fund managers have the flexibility to avoid the disastrous consequences of extreme market events, a view that is well
Figure 1.
accepted by academic and industry experts. A recent publication by Moody’s Investors Service (2010), for example, said: “Because of the inherent flexibility and diversity of the industry, collectively, hedge funds can adjust to market conditions and can continue to produce positive returns even in a recession or bear market, once the initial shock has run its course.”2 In this paper, we explore the experience of hedge fund investors during the Great Recession. We look closest at funds of hedge funds, and also consider the average performance of convertible arbitrage, long-short equity, fixed income arbitrage, event driven, and global macro funds.3
Performance of hedge funds during the Great Recession
Average Monthly Returns
Correlation with a 60/40 equity/bond portfolio
November 2007 through February 2009
March 2009 through February 2010
Fund-of-hedge-funds index
–1.6%
0.8%
0.67
Convertible arbitrage hedge fund index
–2.0%
2.9%
0.63
Long-short equity hedge fund index
–1.5%
1.6%
0.78
Fixed income arbitrage hedge fund index
–1.9%
2.1%
0.70
Event driven hedge fund index
–1.3%
1.8%
0.69
Global macro hedge fund index Dow Jones U.S. Total Stock Market Index Barclays Capital U.S. Aggregate Bond Index 60/40 equity/bond portfolio
0.0%
0.9%
0.33
–4.2%
3.9%
—
0.4%
0.7%
—
–2.3%
2.6%
—
Notes: The hedge fund indexes are from the Lipper TASS database. The 60/40 equity/bond portfolio is based on the Dow Jones U.S. Total Stock Market Index and the Barclays Capital U.S. Aggregate Bond Index.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
1 Equity market returns are those of the Dow Jones U.S. Total Stock Market Index. 2 See also Fung and Hsieh (2001). 3 For a detailed description of these hedge fund categories, see Philips (2006). We used Credit Suisse/Tremont hedge fund indexes, which reflect assetweighted average returns. For a hedge fund to be part of one of these indexes, it must have a minimum of $50 million in assets under management and a track record of at least one year. Credit Suisse/Tremont does not have an index for funds of hedge funds. For these, we used a Barclays Capital index based on the average return of all funds of hedge funds in the Barclays database.
2
The crash, and the rebound In Figure 1, we report the performance for the hedge fund categories, the broad market indexes, and the 60/40 portfolio of equities and bonds. We divide the period since the peak in October 2007 into two subperiods, the equity market crash from November 2007 through February 2009 and the rebound from March 2009 through February 2010.
In the first period, while the equity market crashed at the average monthly rate of –4.2%, the average returns for the various hedge fund categories were in the range of –2.0% to –1.3%, with the exception of global macro hedge funds, which as a group seem to have avoided the crash completely. Thus, all the hedge fund categories did avoid the extreme crash experienced by the equity market. However, the 60/40 portfolio of equities and bonds also would have cushioned the fall to a similar degree; it had average monthly returns of –2.3% over the same period. In the second period, during the rebound, the broad equity market produced an average monthly return of 3.9%, significantly higher than the average returns for any of the hedge fund categories. The 60/40 diversified portfolio produced an average return of 2.6% per month; only the convertible arbitrage hedge fund category produced a better monthly average return, of 2.9%.
Figure 2.
Equity and bond market performance versus fund-of-hedge-funds performance
November 2007 through February 2010 120%
100 Cumulative return
The performance of the fund-of-hedge-funds category in particular may provide insight into the impact of the recession on investors because these funds claim to have the expertise to pick superior hedge funds, thus saving investors the trouble of picking winners. We compare the performance of the various groups of hedge funds to that of the broad equity market (as represented by the Dow Jones U.S. Total Stock Market Index), the bond market (the Barclays Capital U.S. Aggregate Bond Index), and a 60/40 portfolio of equities and bonds rebalanced monthly.
80
60
40 Oct. 2007
Feb. 2008
Jun. 2008
Oct. 2008
Feb. 2009
Jun. 2009
Oct. 2009
Feb. 2010
Barclays Capital U.S. Aggregate Bond Index Dow Jones U.S. Total Stock Market Index 60/40 equity/bond portfolio Fund-of-hedge-funds index
Notes: The 60/40 equity/bond portfolio is based on the Dow Jones U.S. Total Stock Market Index and the Barclays Capital U.S. Aggregate Bond Index. The fund-of-funds index is from the Lipper TASS database. Sources: Vanguard Investment Strategy Group calculations based on data from the International Monetary Fund (IMF), MSCI, and Thomson Financial Datastream. Market-capitalization weights percentages of the MSCI All Country World Index. GDP 1represent also reports the monthly correlation between data for 2010 are IMF estimates.
Figure the average returns for the hedge fund groups and the return of the 60/40 portfolio for the overall period November 2007 through February 2010. With the exception of global macro hedge funds, all the other categories have a very high monthly correlation with the 60/40 portfolio. The fund-of-hedge-funds index has a monthly correlation of 0.67, which raises the question of how “alternative” this asset class is.
120
100
6
B
D 80
60
40 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-103
F
Figure 3.
Equity and bond market performance versus hedge fund performance
November 2007 through February 2010 120%
100 Cumulative return
Funds of hedge funds Figure 2, on page 3, plots the cumulative returns of the fund-of-hedge-funds index, the equity and bond markets, and the 60/40 portfolio. (Figure 3 does the same for four of the other hedge fund categories, and Figure 4 covers the global macro index.) On average, the experience of investing in a fund of hedge funds was very similar to that of investing in a 60/40 equity/bond portfolio. It’s important to note that, although investors can easily obtain access to a 60/40 equity/bond portfolio, they can’t invest in a fund-of-hedge-funds index—they have to pick an individual fund of funds. And while investing in a fund of funds resolves the dilemma of how to pick a single fund, investors still must pick a fund of funds that is good at picking winners.
80
60
40
We also analyzed the returns of individual fund of hedge funds as reported to the Lipper TASS database over the period November 2007 through December 2009.4 We looked at the returns of funds of hedge funds that provided performance data for the whole period, net of fees, reported monthly. In all, 773 funds of hedge funds met these criteria. An investor, of course, would typically pick one of these funds. Of the 773 funds of funds, only 32 produced returns better than the return of the Barclays Capital U.S. Aggregate Bond Index. Furthermore, roughly two out of three of the funds of funds (482 of 773) did worse than a 60/40 equity/bond portfolio.
Oct. 2007
Feb. 2008
Jun. 2008
Oct. 2008
Feb. 2009
Jun. 2009
Oct. 2009
Feb. 2010
Barclays Capital U.S. Aggregate Bond Index Dow Jones U.S. Total Stock Market Index 60/40 equity/bond portfolio Event driven hedge fund index Fixed income arbitrage hedge fund index Long-short equity hedge fund index Convertible arbitrage hedge fund index
Notes: The 60/40 equity/bond portfolio is based on the Dow Jones U.S. Total Stock Market Index and the Barclays Capital U.S. Aggregate Bond Index. The hedge fund indexes are from the Lipper TASS database.
Conclusion We find that hedge funds did provide insulation from the extreme stock market crash of the Great Recession. However, only one category, global macro funds, provided significant diversification beyond that of a 60/40 portfolio of stocks and bonds. Further, individual investors have to choose one particular hedge fund, or fund of funds, and would thus face much higher risk than that of a hedge fund index.
120
100 4 We downloaded the data on March 18, 2010. Because many funds are late in reporting their performance, we used December 31, 2009, as a cutoff for this analysis.
80
60/40 e
Barclay
Dow Jo
Event d
Fixed in
4
60
Long/S
Figure 4.
Equity and bond market performance versus global macro hedge fund performance
November 2007 through February 2010
References Bhardwaj, Geetesh, 2010. Alternative Investments Versus Indexing: An Evaluation of Hedge Fund Performance. Valley Forge, Pa.: Investment Counseling & Research, The Vanguard Group.
120%
Fung, William, and David Hsieh, 2001. The Risk in Hedge Fund Strategies: Theory and Evidence From Trend Followers. Review of Financial Studies 14(2): 313–341.
Cumulative return
100
80
Moody’s Investors Service, 2010. Hedge Funds: 2009 Review and 2010 Outlook. New York.
60
40 Oct. 2007
Feb. 2008
Jun. 2008
Oct. 2008
Feb. 2009
Jun. 2009
Oct. 2009
Feb. 2010
Barclays Capital U.S. Aggregate Bond Index Dow Jones U.S. Total Stock Market Index 60/40 equity/bond portfolio Global macro hedge fund index
Notes: The 60/40 equity/bond portfolio is based on the Dow Jones U.S. Total Stock Market Index and the Barclays Capital U.S. Aggregate Bond Index. The global macro hedge fund index is from the Lipper TASS database.
Philips, Christopher B., 2006. Understanding Alternative Investments: A Primer on Hedge Fund Evaluation. Valley Forge, Pa.: Investment Counseling & Research, The Vanguard Group. Philips, Christopher B., and Francis M. Kinniry Jr., 2008. Market-Neutral Investing—Strategy Overview and Evaluation. Valley Forge, Pa.: Investment Counseling & Research, The Vanguard Group.
120
100
74% Did not opt 80
60
10-year excess returns 10-year excess returns 10-year excess returns 1-year excess returns: 1-year excess returns: 1-year excess returns:
40 Oct-07 Nov-07 Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10
120
100
60/40 equity/bonds portfolio Barclays US Aggregate Bond index Dow Jones U.S. total stock market index
80
Global macro hedge fund index 5
60
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