Working from a database drawn from 13F filings, authors of a new report from Goldman Sachs Asset Management maintain: (1) hedge funds tend to overweight equities in three markets: information technology, consumer discretionary, healthcare; (2) quarter-on-quarter turnover for equity hedge funds’ portfolios is limited; and (3) a long-only sample portfolio drawn from the 13F filings produces a very high correlation with equity hedge funds’ returns.
The unnamed authors of the GSAM report says that their findings are useful for market participants in four ways: X-raying individual funds allows their evaluation and allows their investors to determine if there is style drift underway; more broadly, aggregate data leads to an understanding of industry and style tilts and exposure. Pragmatically, the information captured in the 13Fs can direct portfolio construction by those who want to track the returns of hedge funds in a transparent and cost-efficient way. Finally, the information in such filings can give warnings about when a trade has become crowded.
Axioma Risk-Factor Model
GSAM reached the above conclusions using the Axioma US Medium-Horizon risk factor model.
They use a 10-factor model, where half the factors are market-based, and the other half are fundamental. The fundamental factors are: value (book-to-price); leverage; growth, RoE; and dividend yield. The market factors are: liquidity; market sensitivity (one-year daily beta); volatility; market cap; and medium-term momentum (the cumulative return over the past year excluding the most recent month).
This model allows for a decomposition of portfolio risks into their aspects and drivers.
The authors first computed the overall active risk of the equity hedge funds in their database, defined as the difference between portfolio weights and index weights. Then they decomposed it into risk characteristics driven by the industry, style, or specific risk.
The active risk associated with the third of these, specific risk, which is driven by investment decisions such as the stock selection skill implicit in a portfolio.
The authors found that the active risk as measured versus the Russell 1000 was fairly consistent. That is, it ranged in a narrow band around an average expected annualized volatility to 2.5%.
This left the overall hedge fund portfolio exposed to directional equity benchmark risk while leaving a substantial active exposure where hedge fund managers deviate from the equity benchmark-driven returns.
Decomposing Asset Risk
In decomposing that asset risk, the GSAM authors found that on average its largest part (41.3%) is driven by style factors such as value or momentum. Industry tilt accounts for another 22.3%. This leaves specific risk at 36.5%.
In recent years, that specific risk number has declined. It was 55.5% in November 2009, according to the filings. But it is on something of a bounce from its low of 17.6% in August 2016. The GSAM report doesn’t do much by way of speculating about the reason for its moves, although it does suggest that the stock selection element of specific risk may have been on the upswing from two summers ago because hedge funds perceive a larger opportunity set there now.
At any rate, it is an important discovery—and not especially intuitive, at least not to some of the “intuitors,”—that stock selection risk turns out to be an economically relevant aspect of hedge fund active returns.
Getting More Granular
It is by looking into this aspect in a more granular way that the authors reached their industry-specific conclusions. Equity hedge funds are overweight IT, consumer discretionary, and healthcare. One would expect that they must be underweight somewhere, which is consumer staples, industrials, telecom, and utilities.
From a theoretical point of view, GSAM’s most important findings may involve liquidity and momentum. Hedge funds apparently aren’t in the business of harvesting the liquidity premium, although “the liquidity terms of investments into hedge funds would enable them to do so.” Rather they are on the other side, preferring higher liquidity names.
Further, hedge funds invest in equities with positive momentum. Of course, capturing momentum is tricky. The effect cannot be counted on for more than a year, so a portfolio-wide use of the momentum effect requires a lot of turnover, entailing transactions costs. But hedge funds in pursuit of alpha pursue precisely this effect.