|Summary: Equity investors tracking the S&P/ASX 200 Index were able to achieve returns of about 24% over the 12 months to July. Out of 16 general hedge fund strategies, only two beat the market, demonstrating that different strategies often produce very different outcomes.|
|Key take-out: Year-to-date figures show the market is underperforming against a number of different hedge fund styles, highlighting that the performance of the market itself is subject to extreme swings.|
|Key beneficiaries: General investors. Category: Portfolio construction.|
Australia’s hedge fund sector has put in a very mixed performance over the past 12 months, demonstrating once again that different investment strategies often produce very different outcomes.
Indeed, while all of the best performing hedge fund strategies in the year to July were equities based, only two strategies managed to outperform the broader sharemarket as measured by the S&P/ASX 200 Index. These were Equity 130/30 and Equity Long. But the story is different for the year-to-date, with the market underperforming against a number of different hedge fund styles.
Over the past 12 months, the one broad strategy that performed strongly was Equity Long, with an average performance of 26.37%, benefitting from the broadly rising market.
A Long-Only fund is one that takes only long positions in stocks, seeking to outperform the market by taking concentrated positions in selected stocks. They reduce volatility and downside risk by holding varying amounts of cash.
Some might question why “long only” funds are included in this analysis. But such funds generally have very concentrated, high conviction portfolios, some with only 15 or 20 positions, and many are able to adjust overall market exposure by holding significant cash exposures.
Equity 130/30 performed even better over the 12 months, with a performance of 29.62%. Why? Because in equity 130/30 the manager short sells 30% of the portfolio by value, and uses the proceeds to increase their long exposure to 130%.
Providing the stock selection is on target, the overweight long positions outperform the market, and the short positions either provide some protection or add to performance if those stocks fall in value.
That’s great in a rising market, but the opposite can occur if the market declines and the manager is locked into an overweight long exposure. This is clear when looking back over the seven year strategy performance table at the start of this article.
Generally when the market falls, Equity 130/30 funds suffer more than the index and other equity funds as the leverage they provide magnifies the extent of the downside risk.
It is worth noting that there are variations to Equity 130/30, such as 120/20 and 150/50. The logic and implementation tend to be the same, with the difference being the extent of the leverage or market exposure. Effectively these strategies all have fixed net exposures (calculated as their total long positions minus their shorts) of 100%, but with gross exposure (long plus short) of 140%, 160% or 200%.
Critics of the 130/30 style argue that being locked into a fixed market exposure in all market conditions doesn’t provide sufficient flexibility to dial the portfolio’s risk levels either up or down as conditions change. However, the strategy is gaining new followers amongst both fund managers and investors, particularly amongst previously long only advocates who are trying to find some risk mitigation in falling markets. Others argue that the leverage created by the gross exposure increases returns, but like all leverage also increases risk.
The alternative to Equity 130/30 is simply Equity Long/Short, which implies that the level of long, short, gross and net market exposure adjusts in line with the fund manager’s view of the prevailing market and specific stocks.
Normally these funds have a bias to the long side of the portfolio, but performances are governed by both their stock selection and overall market exposure. These funds make up the majority of the “actively managed” universe, both in Australia and overseas.
This in turn does create some bias in these performance tables as they are not adjusted for the weight of funds under management. Equally, in those strategies with fewer funds, the potential for statistical risk is greater. As always there’s no substitute for research, and understanding each fund’s investment strategy.
Variability of Performance
The table below shows the performance of each strategy in Australian Fund Monitors’ database over the past seven years, and highlights the inconsistency of performances and that of financial markets in general.
There are a number of clear messages to take from this table, in addition to the obvious one that the performance of the market itself is subject to extreme swings.
Firstly, when the market performs strongly (2007, 2009 and 2012) it outperforms most alternative or active strategies. However, when the market falls or performs badly, such as in 2008, 2010 and 2011, nearly all alternative and actively managed strategies perform better than the market.
This is logical and to be expected. Generally non-equity assets and markets are not correlated to the sharemarket (although this didn’t hold completely true during the GFC) and the “short” side of many hedge fund portfolios acts much like an insurance policy. When the market goes up and the short positions underperform, you don’t need insurance, even though you have paid for it; but when the market goes down the short insurance “pays” for itself.
It’s not quite as simple as that of course, as the ability of many fund managers to reduce their overall market exposure by moving to cash in negative markets also provides a significant opportunity to avoiding risk.
Equally, different funds within each strategy can provide wide ranging performances depending on the skill and implementation of their respective portfolio managers. The chart below, for instance, shows the performances of individual funds over the past 12 months, which range from -50% to 75%.
Just as the various sectors of the stockmarket are subject to different performances over time, so too do fund strategies and styles of portfolio management differ over the investment cycle.
This makes an investor’s selection of managed funds, and particularly actively managed and alternative funds, vital to their portfolio’s performance.
Chris Gosselin is chief executive officer of Australian Fund Monitors Pty Ltd. www.fundmonitors.com