So Much for Non-correlation in Hedge Funds

Hedge funds are now allowed to advertise to the general public and boy are they going to need it.  Recent data not only shows abysmal performance, but increasing mutual fund-like characteristics (which is usually a bad thing).  Jacob Wolinsky of Value Walk recently cited a Morgan Stanley report discussing some trends in the hedge fund industry:

“In terms of correlation, the S&P 500 correlation with the HFRI Equity Hedge Index is moving up. Basically,investors are paying 2/20 to buy a closet index fund. As Parker puts it (in a much more eloquent fashion) ‘Hedge Funds in Aggregate Are Essentially Long the S&P 500′. See the chart below.”

hfri

It’s not terribly surprising that the correlations have increased as the industry has grown and macro trends have dominated, but it is surprising to see the correlations this high.  Jacob is precisely right.  If you own a hedge fund these days there’s a VERY highly probability that you’re getting gutted on fees to do what an index fund could do.

The performance data only makes it look worse.  As you can see below, the growth of the industry has also coincided with reduced alpha generation.  And someone please correct me if I am wrong, but the HFRI doesn’t even account for survivorship bias, which, if included here would likely make this trend look much worse.

hfri2

I hate to be so general about this when there are clearly some funds that are probably worth owning for various reasons, but it’s kind of amazing that the 2 & 20 fee structure has lasted this long.  At this rate the fee structure of the hedge fund industry is beginning to look a lot like a legalized scam.  And now that scam is going to be sold to every mom and pop in the mainstream media when hedge funds unleash their vast coffers (ahem, the fees you paid into them in the first place) to convince more people to buy into them….Some people would call that sort of arrangement a ponzi scheme….

* And just in case anyone is curious, yes, I’ve looked at the risk adjusted numbers and they show similar 10 year trends.  The HFRX has returned just 2.24% per year with a standard deviation of 11% while bonds have generated 5.76% at 8.6% standard deviation while stocks have generated a 8.8% return at 18.3% standard deviation.  Now, I didn’t run Sortino ratios and volatility is hardly a comprehensive measure of risk, but the numbers validate the trends above.  As the sample set grows the hedge fund world is starting to show all the same trends of underperformance that are seen in the majority of mutual funds…..

See also:

A Disturbing Trend I see in Hedge Fund Returns

Hedge Funds Are Getting Their Teeth Kicked in this Year

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. When people like you start throwing the word “scam” around with the word “hedge fund” I expect ears to perk up. I wish more people would call these funds what they really are. They’re just legalized forms of theft.

    • Yeah, after reading previous posts regarding hedge funds, my first thought upon seeing the title for this one was the word “scam”. These guys are charging exorbitant fees and providing little value in return. Hell, you could park your wealth in a diversified index fund and chance are you will get just a good return on your money, with the added plus of having ready access to your wealth. You would think high net worth investors would be more sophisticated, but apparently this is not the case – they are being taken for a ride.

      The hedge fund industry (and so much of the financial services industry) is about wealth extraction, plain and simple. Slick hucksters enticing trusting savers with the notion that they have special skills/knowledge that will enable them to achieve significantly above average returns. People want to feel that they are on the inside, part of an exclusive club, and have access to this financial guru. And like spiritual gurus, what they offer is all ephemeral supported by little substance.

        • I prefer Alternative Investment Funds at this point, the name is a historical hold over.

  2. On the plus side, the SEC rules also allow for start ups to advertise to the general public as well. As you see it, is it a good or bad thing given that it better meets your definition of a true investment — albeit a risky one?

    • I guess one should make a clear distinction here. People and firms who put money in start-ups are normally professional *investors*. Not comparable to mom and pop *savers*.

  3. I’m not surprised correlation is increasing. None ,or low correlation is virtually adopting tactics of ‘fight the fed’, and no hedge fund is big enough to succeed in that.
    I think this ties in with the HFM who retired recently saying he felt he had no hedge left in these markets. In effect to paraphrase what he was saying was that as a bottom up analyst he didn’t feel he could outperform the topdown market more ,or less controlled by the Fed. Or not to the extent that he could justify the funds fee structure.
    I think this all ties together with my view that in my life time of market interaction I don’t think I have ever seen a market that has been so dominated by central bank policy for as long as this one.

    Looking forward thought to the day when such a situation changes, and it will change then I can see some people getting caught out by a reversal in that correlation. They will tend to keep on doing the top down thing ,but in reality it will be the ‘pickers’ and bottom up guys who will come back to outperform.

  4. One thing is 100% correct – there are too many wanna-bes in HFs (low average alpha – to none, looks like a zero sum game) and too many managers engaged in hidden or aggressive beta, selling it as alpha.

    So one needs to be extremely selective with hedge funds – invest only with the best 1-5% and one needs to be sure they are the best and understand what they are doing. Second, one needs to make sure what are the hidden systematic and tail risks. Third, one needs to be sure what they do is repeatable.

    Then, using correlation to judge what a fund (or group of funds) is doing is wrong and misleading. You need to use beta. A fund with a high level of stable alpha and a 10% net exposure to the S&P 500 will have a beta of 0.1, but a correlation of 0.8-1.0.

    Another problem is that policy maker intervention has made markets devoid of own will, so everybody is like a Pavlovian dog, waiting to hear from the great Maestro. So yes the correlation (and most importantly beta) has increased.

    To give you an example of a good portfolio:

    Return: Portfolio 7.8% p.a.; S&P 500 TR: 3.4% p.a.
    Vola: Portfolio 6.1% p.a.; S&P 500 TR: 18.2% p.a.
    Sharpe (2%): 0.93; 0.17
    Max. Drawdown: -16.8%; -50.95%
    Beta: 0.2
    Correlation: 0.6
    Alpha: 7% p.a.

    • “So one needs to be extremely selective with hedge funds – invest only with the best 1-5% and one needs to be sure they are the best and understand what they are doing. Second, one needs to make sure what are the hidden systematic and tail risks. Third, one needs to be sure what they do is repeatable.”

      If it was both understandable and repeatable, it would never be repeatable. Capice? There are not too many fools out here, but then I didn’t write the above.

    • Actually, I should better say “It would soon cease to be repeatable”, which of course would beg the question “How do I decide based on past performance?” You can’t.

    • The best 1-5% of hedge funds, of course, won’t take our money unless we have $5+ million. In some cases, they won’t take it no matter how much we have. So the practical consequences for any individual investor, even one with respectable wealth, is that putting money in hedge funds is a winner’s curse. You will only be able to put money into hedge funds that are bad enough to want your money.

  5. They are certainly overpriced, but I wouldn’t call it a “scam” just because of that.

  6. I’m distrustful of the value of having non-correlated assets. You want your investments (or savings) to grow while managing the risks. I’m not so sure that having non-correlated assets helps you achieve this, or that correlation is an effective measure of risk.

  7. First, correlations are fluid and change for many reasons. High correlations to the S&P 500, when the S&P 500 is breaking all time highs, is a good thing. The skill of a hedge fund manager is his ability to shift exposures and affect correlations when things are bad. If a hedge fund had low correlation to the S&P 500 over the last 24 months, it would have mostly likely performed poorly. Third Quarter of 2011 is an exception, as correlations remained high, but I don’t feel that is enough of a reason to condemn the whole hedge fund universe.

    Third, and more importantly, there have been many studies that show when “hedge funds” are grouped together, as they are in the HFRI Indices, they tend to mute the specific diversification advantages of individual managers because they tend to offset each other in terms of diversification benefit. If there is lesson from rising correlations in “hedge funds”, I think its that “hedge funds” is not a real category of investment and should not be lumped together that way. The benefit of owning hedge fund beta funds is most certainly a flawed concept, but seeking out and investing in good managers with niche strategies and differentiating skills is most certainly of benefit and should not be discounted based on this information.

  8. I agree with much of what you’re saying when looking at the industry in aggregate. As I say in my article, the key is finding the good managers who are really earning their stripes. I don’t think it’s helpful for the public outside of our industry for us to use sweeping generalizations. As both of us know, everything in investing requires careful discernment.

  9. Ha, obviously I missed a “Second” in there….which is, that most certainly the explosion in number of managers in the hedge fund space also leads to this rise in correlations, on average. A better measure would be to look at the dispersion of returns on “hedge fund” managers. I don’t have the data in front of me, but I’m confident that the dispersion from the top to the bottom would be wide. Much wider than that of say Large Cap Value managers. This has always been the case with “alternative” asset classes. Private equity being the prime example. Exposure to “hedge funds” or “private equity” isn’t enough. You need exposure to GOOD hedge funds and private equity. The same cannot be said for long only equity managers, who tend to mirror the broad market in a much tighter range.

  10. Correlation is an over-used metric. There are some long-only value managers whose long-term correlation to the market is in the mid .8′s yet they’ve outperformed by hundreds of basis points.

      • Yep, I know. But my point was, hedging or not, you can have high correlation and generate alpha at the same time. The above post laments the high correlations of hedge funds, yet maybe correlation isn’t as meaningful a data point as many think…

  11. Trend is well documented but isn’t there an (long standing) argument to made here that if you pic good managers they outer-perform? Granted many managers say they’re special and unique then are overweight Google or whatever the hotel de jour is. But some really do just go out kill it.

    • That’s the problem. As the industry grows it’s getting harder and harder to find the guys who are adding value. And odds are, if they are adding value then they don’t want your money anyhow….

      • Agree on all that _as a function_ of the expanding environment.

        If correlation with the market continues and gets narrower, who’s to say the industry doesn’t shrink as the investors who can’t get into the good managers’ funds avoid HFs all together? Just saying the current trend may not be indicative of the future of the industry.

        Agree the alpha game has changed drastically.

  12. The Fed is targeting asset prices on a daily basis thus making fundamental analysis irrelevant, and the SEC has scared away the insider traders and expert networkers after Galleon, SAC et al, and so right now hedge funds have no edge over a macro index like the S&P 500 or Russell 2000.