When the Hedge Fund Industry Evolves…in a Bad Way

That headline probably has you wondering – is there a way hedge funds can evolve in a good way?   Of course there is.  But this story is troubling recent development that’s the result of a bad evolution in the hedge fund industry – hedge funds and their extremely high correlation to the S&P 500.  One of the things that made hedge funds (many of them) so attractive as an asset class was their non-correlation to the S&P 500.

The other day I discussed how the biggest problem with active money managers is that most don’t create any value.  And they don’t create any value because they have no competitive advantage.  And they have no competitive advantage because they’re not doing anything unique in their strategies.  The best funds are not the ones who try to mimic the S&P 500 and happen to outperform them.  I can get S&P 500 returns through an index fund.  But give me a fund with non-correlation and high risk adjusted returns in a strategy I can’t access through Vanguard and we’re adding value to the portfolio.  We’re diversifying risk across different approaches and adding alpha in a way that differentiates us from your standard 60/40 stock/bond fund.  That’s value.

So it’s disconcerting when you see a chart like this which shows how hedge fund correlations are gravitating towards the S&P 500 (via Value Walk):


The worry here is that hedge funds are becoming a lot more like mutual funds which just mimic a highly correlated index and add no real value.  Except these funds are charging you 2 & 20 for it.  As the HF industry gets larger you have to be much more selective about the funds you input into your portfolio.  And if the trend continues it’s possible that we will have to exclude them completely (primarily because the few good ones will be impossible to get into).

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.

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  1. Correlation is an overrated metric. There are value managers who are highly correlated to the broad market that have produced outstanding results even though the indexes have gone nowhere. There are alternative strategies with zero correlation (think managed futures) that are just awful. Hedge funds in aggregate are evolving in a bad way because, just like their mutual fund counterparts, they are sheep, crowding into the same trades (think long AAPL), not recognizing value, and giving themselves no margin of safety. Except with much higher fees.

    • Agree with all except for that Managed Futures are awful: here as it is everywhere in HFs, there are too many bad managers. Optically MF look awful, because they cannot hide behind illiquid instruments. Adjusting less liquid strategies for illiquidity (see Asness paper), their sharpe ratios drop and become comparable to those of MFs.

  2. These things are “HINO’s”: Hedge in name only.

    We need a truth in labeling law.

  3. i´d argue that this development isn´t the fault of the HF industry.
    i´m pretty sure there are a lot of money managers out there looking for total return and capital preservation.

    the thing today is that this kind of of behaviour isn´t rewarded by INVESTORS at all.

    negative performance in a falling stock market? that can happen.
    but underperforming while the stock market rallies? almost suicidical. your job´s in highest danger.

    with these given conditions the bias to just play along the S&P is pretty high.

    (other factors might include a lazyness to just ride the feds liquidity wave and a heavily weighted AAPL stock which is a hedgie favourite too)

    todays HF managers are simply a product of their investors…

  4. I was going to write something interesting about the differences between “40 Act” funds and HF’s. But I happened to notice that the correlation graphs actually imply something possibly more profound. The long-term correlation chart goes back nearly twenty years and captures a variety of market environments, while the 1, 3, 5 year bar chart only captures the peak of the SP500 forward.

    I suggest that the unprecedented interventions by central banks, not just here but around the world, have played a significant role in higher correlations across the board. Absent most of 2008, many credit instruments, and credit-related strategies for that matter, were hit unusually hard due to both the Lehman unwind and the widespread inability to fund carries in the aftermath of the collapse of wholesale funding markets. Essentially, 2009-to-present has been a one-way market for nearly all assets.

    Arresting the decline in those assets serving as collateral on bank balance sheets in an effort to stave off a perceived deflationary nightmare was necessary in Bernanke’s eyes. From the technocrat viewpoint of, “let’s fix the immediate crisis now and deal with the consequences later,” it’s been a success. Ignoring, of course, the real world implications of such policies.

    Correlations went asymptotic in 2008, and have broadly remained elevated since due to QE distortions. I may be wrong, but that’s my opinion.

  5. By the way – not sure I understand the usefulness of that chart. It shows rolling 1 year correlations of hedge fund strategies to the S&P 500, but the hedge fund data is only provided monthly…meaning the correlation calculations were done using only 12 data points. Not very robust. At a minimum, rolling 3 year periods should be used to provide a useful analysis of the data.

  6. Isn’t the world of investing, banking, finance, economics, and even accounting full of misnomers? Something I read a month or two ago pointed out that “hedging” is not really what hedge funds do.

    Let’s see if I can think of other examples…. how about “securitization” of sub-prime mortgages?

    • Actually, read David Stockman’s recent piece on LBO firms… he has fun with “exploiting synergies.” Makes me think that being a BS artist is the main talent required!

  7. On top of the critique that hedge funds do not hedge and herd and there are too many wanna-bes, there is another important factor:

    Correlation is not beta. I run a portfolio of hedge funds that has a correlation to the MSCI World of 0.75 (12-month rolling basis over the last 3 years). Guess what, this portfolio has a beta to MSCI World of 0.08.

    Thus our portfolio suffered only modest drawdowns during the latest three equity market “risk off” episodes (-1.9% between April and June 2010, -1.6% between July and September 2011, and -0.7% between April and June 2012; during the same periods the HFRI Fund Weighted Index experienced drawdowns of -3.8%, -7.0%, and -3.3% respectively and the S&P 500 TR index suffered losses of -12.8%, -16.3%, and -6.6% respectively).