By: Neil Kotecha, CAIA, BNY Mellon Wealth Management. Member, AllAboutAlpha.com Editorial Board
With last year’s returns finalized, some are questioning the effectiveness of equity long/short hedge funds. After posting losses in excess of 26% in 2008, the HFRI Equity Hedge Index failed to outperform the MSCI World Index in 2009. So, do these two years prove the cynics’ skepticism of equity long/short hedge funds right?
The short answer is no. While many funds failed to meet their individual objectives over the past two years, the broad group was successful in achieving its primary purpose, which is to hedge equity risk. To come to a comprehensive conclusion, performance must be analyzed through this objective-driven prism rather than in a total-return vacuum. Below is a review of the two-year period as well as the last full bull and bear markets.
2008 & 2009
The two years of 2008 & 2009 were among the most volatile in the histories of long-only equity and equity long/short investments. The loss of 40.71% among global long-only equities in 2008 was followed by a 29.99% gain in 2009. Similarly, although less extreme, equity long/short hedge funds lost 26.65% in 2008 and rose 24.96% in 2009. The graph below illustrates the impact of successful hedging on volatility and total returns. Note how hedging protected the downside in 2008 while still being positioned to capture much of the gains after the market bottomed in March 2009.
Bull Market (October 1, 2002 – October 31, 2007)
The last full bull market occurred between October 2002 and October 2007 (the current bull market that began in 2009 may not yet be complete). During this time, equity long/short hedge funds underperformed global equities substantially. However, the table below illustrates that they did so while experiencing far less volatility and smaller drawdowns, leading to superior risk-adjusted returns.
Risk-agnostic investors, seeking greater total returns, would have been best served with a full allocation to long-only equities rather than hedging their exposure. But that assumes an investor entered at the trough and exited at the peak, and can tolerate the market volatility in between. This type of market timing is extremely difficult to achieve, as this October 2009 AllAboutAlpha.com article discusses.
Bear Market (November 1, 2007 – February 28, 2009)
The most recent bear market adversely affected hedge funds across the board. Although equity long/short funds fared better than their fixed income or multi-strategy brethren, since they did not suffer from the liquidity crisis nearly as much. Nevertheless, many investors were disappointed in their performance as they experienced significant drawdowns. This is at the heart of issue: Expectations seemed to be misaligned with realty. As mentioned earlier, equity long/short hedge funds are meant to reduce volatility and drawdowns from equity exposure (i.e. hedge), not eliminate them. So it is reasonable that these funds posted losses when global equities fell 54.03% during this period.
The following table demonstrates the added value of equity long/short funds during the bear market. It’s worth stating that the time period was too short to use some statistics.
Equity long/short funds suffered roughly three-fifths of the losses experienced by those in long-only equities. Short exposures and cash positions partially protected against losses. Investors may be disappointed by this drawdown, but should be encouraged as up-capture exceeded down-capture and the 50% level, albeit barely.
Aggregate Period (October 1, 2002 – February 28, 2009)
Looking at the aggregate period, equity long/short hedge funds outperformed long-only equities despite underperforming so significantly during the bull market period. Note that 16 months of long-only equity losses during the bear market wiped out all excess returns during the previous 61-month bull market.
It is easy to look at the aforementioned data and conclude that an investor should have been in long only stocks during the bull market then shifted to hedged positions as the stock market turned over. However, depending on the ability to time the market perfectly is extremely difficult and possibly dangerous. This is why most institutions maintain allocations to both long-only and hedged equity investments and tactically change a portion of the allocation as they see fit.
It is important that investors become reacquainted with the objectives and return expectations of equity long short hedge funds. They often seek to hedge equity volatility and drawdowns while maintaining a portion of the upside potential. This means that they usually will not post losses over long term periods, but they may if equity markets fall drastically (as they did in 2008).
In response to cynics, it is safe to counter that equity long/short funds not only did their jobs over the past two years, but that they reasserted their added value. Investors that maintained at least a portion of their equity allocation to hedged positions experienced less volatility and smaller drawdowns than long-only investors. Additionally, they did not sacrifice too much upside in the process.
1. Source: Morningstar Direct©, Hedge Fund Research, Inc., © 2010
Unless otherwise noted the source of all performance information cited herein is Morningstar Direct and Hedge Fund Research, Inc. Past performance is not indicative of future results.