Hedge funds changing tack

18 August 2008

Sailors out there will know that boats can sail down with the wind - like a leaf being blown across the water - or into the wind at an angle, zigzagging back and forth along the way. Sailing downwind is easier and since it offers a direct path from A to B, and is therefore faster. Zigzagging directly upwind, on the other hand, requires more skill and is much slower. But who would want a boat that could only sail along with the direction of the wind? This is where sailing can offer a useful lesson for hedge fund investors.

Since the beginning of the last bull market, questions have been raised about the high correlation between hedge funds and equity markets. Arguably, this relationship gave birth to the field of hedge fund “replication” (a field that now involves a wide variety of “alternative” betas as well).

But all along, hedge funds have said that when markets rise, why shouldn’t they try to capture all this upside - and then some? The value in alternative investments comes not necessarily from their consistent absolute outperformance, but in the option-like behaviour of their returns. In other words, your “2 and 20″ buys you a market put. Long-only managers, hedgies are apt to say, simply don’t have the ability to make dramatic adjustments to net exposure in response to market gyrations.

July’s negative performance for hedge funds has shown that they too seem unable to spin on a dime. However, two reports released last week show that hedge funds are actually able to adjust their aggregate market exposure pretty quickly.

The Hennessee Group, a hedge fund database company, examined the net and gross exposure of long/short equity funds in their database over the past few years and found that net exposure peaked at 52% in Q2 2007 - about the same time the S&P 500 maxed-out (see chart below).

As you can see from this chart, long exposure went from 78% to 114% between 2003 and 2007. Then, just as the market was topping out, net exposure was reduced by nearly 10%. By the end of Q2 ‘08, it was 17% below its 2007 peak.

This is a bottom-up view based on actual holdings. But is this exposure change reflected in the rolling return correlation of hedge funds with equity markets? Another report last week provided us with an answer.

Credit Suisse released this study on the correlation between its broad-based index of hedge funds and the MSCI World Index. As you can see in the chart below from the report, the 12-month rolling correlation was over 0.95 in June 2007, but fell dramatically to around 0.60 by June 2008 (ignore the red circle - that’s something else).

Bear in mind that this report examined the correlation of a broad index of hedge funds, not just the long/short equity category. But the message is the same; hedge funds are charting a new course as the winds of change hit equity markets. Instead of simply sailing downwind on a dead run, they are beginning to turn into the wind. Like sailing upwind, that also requires skill - and it’s slower. As a result, their absolute returns have taken a hit, but if hedge funds can emerge from 2008 with only modest losses, then history may remember this year as the year when hedge funds proved their seaworthiness.