Luke Ellis: 2011 volatility is no repeat of hedge funds’ tough 2008
Yet for every hedge fund that lost, say, 12%, another made money. Not bad in a month when the MSCI World Index (hedged USD) of leading stocks fell -7.0%.
Indeed August showed just how suited hedge funds are to today’s febrile financial markets. If, as seems likely, the West’s indebted economies have entered an era when they lurch between slow growth and recession, then hedge funds appear far more capable of generating returns for investors than straightforward equities or bonds.
Far from being an asset class in their own right, the past few weeks show that hedge funds are really diversification tools sitting within existing asset classes. In the case of Equity Long-Short funds, which account for almost one third of the hedge fund universe, August illustrates how they provide some protection in falling markets, while capturing the majority of the upside in rising markets. Managed Futures and Macro funds, meanwhile, tend to profit from big market moves, such as last month’s.
Hedge fund performance in recent weeks has been significantly different to 2008. The reason is that if banks have difficulty raising funding and aggressively cut the funding they provide, then they make life very tough for hedge funds, with excessive margin calls causing forced selling and a negative price spiral. If a bank that owns a prime broker becomes insolvent, then hedge funds may lose the ability to manage part of their portfolios for some time, creating significant extra problems. So far this hasn’t been happening and so 2011 is not another 2008.
Hedge funds’ performance in August would have provided valuable diversification for any investor with a balanced portfolio of stocks and bonds. Compared with the MSCI World Index’s -7.0% fall, the average hedge fund lost only -2.9%, as measured by the DJ CS Core Hedge Fund Index. This broad average masked a wide dispersion of performance. Funds in the universe we monitor ranged from a loss of -19.5% to a gain of +14.2%.
Among the underlying hedge fund styles, Managed Futures performed best. As stock prices fell and bond prices rose, so managed futures’ systematic trading systems locked onto the trends. The Dow Jones Credit Suisse Managed Futures Index climbed +1.0%. While this average, again, hides a wide dispersion of performances, it shows how well this style of fund captures big market movements across different markets, up or down, and so performing the function of switching between equity and bond investments on a tactical basis that is so important for a pension fund.
For Equity Long-Short funds, August offered little opportunity to profit from security selection. Markets moving this rapidly never do. But the month did show how the managers of these funds tend to avoid losses when equity markets fall. The Dow Jones Credit Suisse Long/Short Equity Index was down -3.6% in the month, only approximately half the fall of stocks globally.
In the longer term, equity prices’ recent extreme volatility will prove the foundation for Equity Long-Short funds’ future gains. At times such as these, relative stock valuations often reach levels far wider than they should be as the market has been focused on headlines and liquidity and not quarterly earnings potential. Skilled managers have an opportunity to buy and sell these stocks, so storing up gains for the future.
Judging the difference between an Equity Long-Short manager with skill and one that has just been plain lucky is easier than normal in a month like August. If you have the advantage of seeing how managers navigate the shorter term rallies and corrections in such violent markets on a daily basis through a managed account, then you learn a lot about their trading styles and behaviours. The past few weeks have revealed more about the hedge fund managers we follow than the entire 2003-2007 equity bull market did.
That is not to say the manager who achieves the strongest performance in times like these is necessarily the most talented. The managers that impressed us most found themselves wrongly positioned for the late-summer outburst of pessimism, but limited the damage. These managers swiftly reduced their funds’ exposures and then stood back awaiting the next opportunity. Erratic markets catch out even the most able managers sometimes; what matters is how they react.
If you believe that the Western world’s debt burden means that its economies are destined for low growth, then hedge fund returns are likely to be more than competitive. European and US equity returns will be low, while highly-rated sovereign bonds will return 2% at best. Moreover, as the US Federal Reserve has made clear, cash interest rates are destined to be minimal for the foreseeable future. So how can you make a positive investment return? On last month’s evidence, and that of similar periods in the past, you need to diversify into hedge funds.