AllAboutAlpha Special Guest Posting by Harry Kat

Today, July 1st, is Canada’s national holiday.  As a result, we watched fireworks and drank “Molson Canadian” with the rest of our countrymen today and avoided blogging.  In Alpha Male’s place, we welcome a special guest poster today in the form of the always controvertial Professor Harry Kat.  Hot on the heels of a recent feature article in the New Yorker, Professor Kat shares his take on a common argument made in favor of funds of hedge funds.   

“Funds of Hedge Funds and the 2000-2003 Equity Bear Market” 

Special to by: Harry M. Kat

At conferences, I tend to make the point that highly diversified portfolios of hedge funds tend to be highly correlated with the stock market and therefore do not make good diversifiers. When doing so, fund of funds salesmen rush to the microphone to point out that funds of hedge funds did not go down during the 2000-2003 equity bear market and that such protection alone is worth paying ‘3+30′ for. For simplicity ignoring the rather alarming fact that it only takes 6 years of paying fund of funds fees to lose the equivalent of a 40% drop in the S&P 500, this indeed looks like a strong point in favour of funds of funds. However, upon further reflection, this is not necessarily the case. In this short note I will clarify this comment. I will concentrate on the HFRI Fund of Funds index. As shown elsewhere, the multi-strategy hedge fund replication products offered by Merrill Lynch, Goldman Sachs, Partners Group and others tend to track this index quite closely.

Figure 1: S&P 500 and HFRI Fund of Funds index, 1996 – 2007


Figure 1 shows the evolution of the S&P 500 (incl. dividends) and HFRI index since 1996. From the graph we can distinguish three distinct phases.  During the first phase, from January 1996 until August 2000, the S&P 500 rose by 166% and the HFRI index went up by 70%. The second phase runs from September 2000 to February 2003.  During this period, the S&P 500 lost 43%, but the HFRI index was more or less flat.  The third and final phase started in March 2003.  Since then the S&P 500 has risen 90%, while the HFRI index has risen by only 47%.

The HFRI index seems to go up when the S&P 500 goes up, so why did it not go down when the S&P 500 came down over 2000-2003?  The answer lies in the dynamics of hedge funds’ exposure to the stock market. When the equity bull market came to an end in 2000, hedge funds increasingly reduced their equity exposure, restoring their exposure when the stock market picked up again in 2003. This is confirmed by Figure 2 below, which shows the results of an annual regression of HFRI index returns on S&P 500 returns. In Figure 2 we clearly see how the exposure of the HFRI index to the S&P 500 drops the further we get into the equity bear market.  In 2004 it is back to where it was in 1999, however.  Note also that in 2006 the HFRI index’s equity exposure increased further to levels not seen at any time before.

Figure 2: Betas HFRI Fund of Funds index with S&P 500, 1996 – 2006.

Figure 3: Volatility HFRI Fund of Funds index, 1996 – 2006.

Well-diversified hedge fund portfolios (and indices) diversify away most alternative risks such as equity and credit risk.  Therefore, hedge funds’ apparent withdrawal from the stock market in 2000 also had a significant impact on the volatility of the HFRI index.  This is confirmed by Figure 3, which shows the annualised volatility of the HFRI index over 1996 – 2006. When the HFRI betas dropped, so did the index’s volatility.  In 2004, however, index volatility did not pick up as much as its beta did. The reason for this, as shown in Figure 4, is that S&P 500 volatility has come down significantly since 2002.  

Figure 4: Volatility S&P 500 index, 1996 – 2006.

Figure 5: Correlation HFRI Fund of Funds index and S&P 500, 1996 – 2006.

It is also interesting to see what this phenomenon did to the correlation of the HFRI Index and the S&P 500. Figure 5 shows that the lower beta of the HFRI index is only partially reflected in its correlation with the S&P 500.  While the HFRI index became less sensitive to the S&P 500 during the 2000-2003 period, the S&P 500 became more volatile.  Figure 5 also shows that the correlation between the HFRI index and the S&P 500 has been remarkably stable over time. The only two years when it dips significantly below its normal level of around 0.70 are 2000 and 2002.

The main reason why the correlation between the HFRI index and the S&P 500 is not higher these days is the exceptionally low volatility of the S&P 500. Given hedge funds’ current exposure to the stock market, however, this correlation can be expected to increase significantly if and when S&P 500 volatility rises (and the part of hedge fund volatility attributable to the S&P 500 increases along with it).

This leaves one critical question though: are hedge funds’ withdrawal in 2000 and their move back into equity in 2003 genuine indications of skill?  Of course, this is a subjective matter since such market timing can be encapsulated in only two decisions. 

Personally, I don’t think it was a genuine indication of skill.  In August 2000, after seeing the S&P 500 go up by 133% in only 4 years time, many investors felt that things were about to change soon. Likewise, in February 2003, after a 45% drop in two and a half years, many investors had the same feeling. I know I did. I know everybody else that I know did, and I suspect that many people that I don’t know did as well. Put differently, it does not seem to have required special skills to be bearish in 2000 and bullish in 2003.

Does this mean that hedge funds didn’t add any value during the 2000 – 2003 bear market?  No, it doesn’t. Hedge funds did what many investors thought of doing, but, for whatever reason, never did or only did when it was (almost) too late. 

The explanation for this is simple and has to do with the way hedge fund managers are paid. Hedge fund managers receive a substantial share of the profits, but do not participate in any losses. Under such a compensation scheme, hedge fund managers tend to be a lot less emotional about their investments than the average investor.  When they are bullish they buy and when they are bearish they sell. By doing so, they make up for many investors’ failure to put their money where their mouth is.

However, as more and more investors are starting to realize, this service comes at a very high price.  They can be excused for wondering whether hedge funds will provide a similar type of protection under different market scenarios – where things are less clear and the downward trend is less prolonged as it was in the 2000-2003 period.  As an avid observer of hedge fund behavior, I wouldn’t bet on it. 

Harry M. Kat
June 27, 2007

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