Clearing the volatility hedge

The returns from absolute return hedge funds over the past year were far from spectacular when compared against the broader market, but on a long-term basis they have been largely in line with the market and have demonstrated far less volatility.

Absolute return funds returned 9.68% in 2012, underperforming the ASX200 Accumulation Index, which returned 20.29%. Against this, funds investing in equity strategies returned an average 12.14%, significantly better than non-equity funds, which managed an average of just 3.52%. 

Overall, 85% of all funds in Australian Fund Monitor’s database provided a positive return, while just 16% managed to outperform the ASX200 Accumulation Index.

No doubt some critics will jump on these figures to argue that absolute return strategies failed to provide attractive returns, let alone value for the fees charged.  Taking 2012 in isolation, and using the above average statistics, this is easy to argue. But in reviewing performance over the past five and 10 years, it is evident this is not necessarily the case. 

In 2012 the spread of returns between funds was once again significant, ranging from minus 45% to plus 56%, proving that in the absolute return sector averages can be dangerously misleading, and manager selection is critical. So is stock selection for the fund managers themselves.

Average strategy returns can be deceptive. Chart 1 shows the distribution of returns of all hedge funds.

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Five and 10-year performance: Volatility eats returns

If 2012 was a year of two halves, so too was the previous decade. For the first five years from 2003 to 2007, equity investors could do little wrong as they overcame, and then forgot, the lessons of the dot-com bubble, just as they had forgotten the previous lessons from other market crises.

For five years from 2003 to 2007 the ASX200 accumulation index had no problem notching up returns of 20% per annum, supported by easy credit, and lax lending at both corporate and personal levels, and volatility fell accordingly.

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Over the five years from 2003 to 2007 the equity market (ASX200 Accumulation) clearly outperformed absolute return funds.

However, comparing only equity-based funds, as detailed in Chart 3, there was little difference in the total return between an equity fund index and the ASX200.  The drag in fund performances from short exposure was easily offset by their long exposure, usually being well over 100% thanks to the significant leverage provided by their prime brokers in those days of easy credit.

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The cumulative returns for the five years from 2003 to 2007 exclude all but the first two months of the GFC. The ASX200 reached its peak early in November 2007, investors having ignored the warning signs that were being signalled by events such as the failure of highly leveraged funds exposed to the US credit and sub-prime housing market such as Basis Capital and Absolute Capital just a few months before.

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Taken as a whole the total cumulative returns of the ASX200 Accumulation Index and the average of all absolute return funds are broadly even, albeit with significantly different risk or volatility.

Key performance indicators

Taking returns on their own, irrespective of the timeframe, only tells one part of the performance story. The other of course is risk, which has dominated markets for the past five years.

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What is clear is that while the total return of all funds, including equity and non-equity funds, is almost identical to the ASX200 accumulation index over the 10-year period, it has been achieved with substantially less than half the risk as shown in table 1 above.

While the ASX200 fell over 44% from November 2007 to February 2009, absolute return funds fell just under 20%. Volatility (standard deviation of monthly returns) of the funds was just 6.23% against the ASX200’s 13.33%.

Equity vs non-equity funds

Separating the performance of the underlying asset class between “equity” and “non-equity” provides significant insight to the benefits and risks of each.

Non-equity based funds provide a low correlation to equity market volatility, which resulted in their underperformance in 2003-2007, and outperformance when equity markets fell during the GFC (albeit with a higher correlation than might have been expected) and lower returns since.  The inclusion of these funds not only lowers overall volatility, but also returns.

However, when comparing the ASX200 Accumulation Index only against equity-based absolute return funds the position changes significantly.

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Interestingly, at least from a statistical viewpoint, equity-based funds have outperformed the ASX200 in four out of the past 10 years. These were both times the market fell (2008 and 2011), and on two occasions (2003 and 2010) when the market rose. On each of the remaining years, the ASX200 outperformed.

The key lesson to be learned from this is clear: the reduction in risk – or avoiding negative returns – is as vital, if not more so, than keeping pace with the market when it is rising, however appealing that might be.

Volatility, or negative returns, destroy the positive effects of compounding.

Chart 6 below “zeroes” the performance of the ASX200 and Australian Fund Monitors’ index of all funds. Although falling 19%, against the ASX200’s fall of 44%, this allowed funds to significantly outperform from 2008 -2012.

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The key performance indicators for these five years tells the same story, and even though the market has performed well in the more recent years, the risk KPIs clearly show the danger and damage caused by volatility.

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Once again, non-equity funds dampened performance and volatility as shown in the KPI table below for equity funds.

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Conclusion

In spite of popular opinion, absolute return and hedge funds are less risky, and less volatile than the underlying equity market. Of course, returns will vary from year to year depending on the underlying macro conditions, and investors should not be tempted to trade individual funds.

What is only briefly covered in this review is the wide range of fund performances which underlie the data. There are undoubtedly funds that have high volatility, and some have average performance or worse. 

The key for investors is to research, then research more.

Chris Gosselin is chief executive officer of Australian Fund Monitors Pty Ltd. www.fundmonitors.com