Who said hedge funds don’t like chaos?

Critics of hedge funds often charge that they simply sell insurance (“volatility”) for a premium and cross their fingers that they never have to pay up.  Hedge funds, they say, are “short vol.”  When volatility goes up, they go down, and vice versa.

But there may be a little more to the story than meets the eye.

Studies have shown that, in theory, active management thrives during periods of time when stocks are less correlated – when the so-called “cross-sectional dispersion” between stock returns is highest (i.e. their average correlation is lowest).

Back in late 2008, we covered a presentation by Steve Sapra of Analytic Investors that contained the following chart showing the average stock-by-stock correlation of US equities (blue line).

Note that correlations were low around the turn of the century.  This makes intuitive sense for anyone investing around then.  Stocks seemed to have a mind of their own as some sectors bubbled, then blow-up while others held the line.  Indeed, as the orange line shows, average stock volatility peaked in the Halcyon days of March 2000.  This combination provided unprecedented opportunities for those who could read the tea leaves at the time.

But does high volatility always lead to opportunities for the most active managers of all, hedge funds?  A report published by Moody’s recently contains an interesting appendix that seems to say “yes.”

The following chart from the report ranks monthly hedge fund industry returns from lowest to highest and shows the corresponding change in the VIX for that month. (Click to enlarge)

If anything, this chart shows that hedge funds have performed better in times of relative calm – that as a whole, they are “short vol.”  When the markets get wonky, hedge fund managers apparently have just as much trouble as the next guy.  Explains Moody’s:

“…although it is true that risk exposures of funds can vary substantially, they are participants in the financial markets and a sudden re-pricing of risk across the board can catch managers off guard, in the same way as other market participants…”

Still, as Moody’s points out, hedge funds are quick learners and are able to adjust their positioning faster than traditional managers.  As a result, they don’t stumble as far and their cumulative performance tends to recover quicker (as the following chart from the report shows – click to enlarge).

So hedge funds may thrive in relative stability.  But they also seem to perform “less poorly” during market upheavals.  This seems to support the argument that active management beats passive management in times of chaos.

However, as Sapra points out, that chaos must be accompanied by cross-sectional dispersion in order for active management to fully realize its potential.

During the ’99-’03 pop in average stock volatility, hedge funds did okay.  But during the 2008 jump in vol, hedge funds took a pie in the face.

The difference?  Average stock correlation was low in the ’99-’03 time period and was astronomical in 2008.

So the bottom line seems to be that high volatility might only be bad for hedge funds when cross-sectional volatility is also high.  Unfortunately the Moody’s report did not account for this variable.

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  1. Sami Al-Bashir
    February 19, 2010 at 12:47 pm

    I wanted to comment on your final point. I agree that an environment of high volatility and high average stock correlation is challenging for active managers but also feel there is a cause and effect that should be noted. As we know, the hedge fund industry was substantially larger in 2008 than 2000, both in absolute terms and as a percentage of market activity (without any hard data I would also strongly suggest that leverage was substantially higher too since financing terms were ridiculously easy in 2007-08). Goldman’s “VIP List”, which tracks the 50 stocks that “matter most to hedge funds”, underperformed the S&P 500 by 11% in Q3 2008 (the report is dated 10/1/08 if you have access to it). That is stunning underperformance for an industry that prides itself on stock picking skill, especially in a period when markets are getting pummeled. What seems to have happened is certain names became extremely crowded and as liquidity was withdrawn by prime brokers after the collapse of Lehman hedge funds simultaneously blew out of positions resulting in 1) massive underperformance of crowded names, and 2) a large rise in correlation amongst these names. Equity based hedge funds that performed well during this period appear to have been in less-crowded names and had a strong short book or general hedges. The bottom line is that while high inter-stock correlation coupled with high market volatility is certainly far from ideal for active managers it appears that, in 2008 at least, high correlation can be caused by those same active managers. Consequently, for anyone investing in hedge funds it is probably wise to research how many their managers’ positions overlap with their industry peers.

  2. Jason Ruspini
    February 19, 2010 at 1:47 pm

    In aggregate, hedge funds are long risky assets and so are short volatility. Managed futures and CTAs have shown themselves to essentially be long volatility however.

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