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At first sight, discussing hedge funds within an exchange-traded fund (ETF) context might appear an odd proposition. Indeed, hedge funds are supposed to deliver "alpha," which in layman's terms refers to returns generated by sheer manager talent, unrelated to the general direction of the market. Each hedge fund manager typically focuses on a specific market opportunity and extracts an economic rent from his/her superior understanding of the securities he/she deals with. At the opposite end of the investment spectrum, ETFs are constructed to deliver the average performance of a given asset class. Designed to mimic the returns of a specific index, ETFs are by definition "beta" funds, meaning not related to any extraordinary returns. |
As Figure 1 clearly shows, the Hedge Fund Research (HFR) Funds of (Hedge) Funds Composite Index has been mostly uncorrelated to the vagaries of the S&P 500 Index, offering a much more stable path of returns over time.
Figure 1
Source: Bloomberg, as of January 12, 2006.
So, why are we discussing hedge funds in the context of ETFs? As we shall see, hedge funds actually share many more commonalities with passive factors than hedge fund managers want us to believe. Indeed, if hedge funds could be shown to rely on passive factors, we might think twice before paying hefty management fees!
Taking Apart The Black Box
For the first part of our analysis, we shall use the HFR Fund of Funds Composite Index as a proxy for the "tradable" hedge fund space. Using this index obviates many of the shortcomings of single-manager hedge fund indexes, which often contain closed funds that are inaccessible to a new investor, making a comparison with easily tradable assets an exercise in futility.
The question is: Can we replicate the returns delivered by the hedge fund space with "plain vanilla," readily tradable, passive market factors? Mind you, hedge funds are often presented as mysterious black boxes that somehow manage to deliver positive performance, even when everything else is down. At the very least, hedge funds are presented as an "all-road" solution, as funds that can do well irrespective of whether the equity market is up or down. Hence, while discussing the nature of hedge funds, you cannot escape the image of the masked magician who reveals the tricks of apparently perfect illusions. Rest assured, we will not discuss the mechanics of making a train wagon disappear, or how to turn a tiger into an attractive woman. However, we will try to take apart the myth that hedge funds walk on water.
Much of the discussion below rests on previous analysis conducted by professors Fung and Hsieh, and Agarwal and Naik, and is heavily indebted to their work. When we think of better understanding hedge fund returns, we need to think about some of the strategies used by hedge funds to obtain their returns. For instance, many hedge funds use leverage to enhance their returns.
Also, a number of strategies aim to take advantage of relative trades of one stock against another. Merger arbitrage typically involves buying the stock of a (smaller) company and shorting the stock of a (larger) company that is attempting to buy out the former. A number of hedge fund strategies also involve purchasing convertible bonds as a way to buy inexpensive imbedded options on an underlying stock via lower-than-market-implied volatility.
When we think about the strategies mentioned above, we can make an educated guess as to what market factors might influence hedge fund performance:
1) Since leverage is commonly used, cash rates might explain some of the performance;
2) As many strategies involve buying and selling stocks, a broad stock index might contribute to explaining the returns. In addition, since a number of hedge fund strategies involve investing in smaller-capitalization firms (e.g., the target firm in M&A transactions, or simply less-well-researched firms), the difference in performance between large and small cap stock might also play a role;
3) Strategies such as convertible bond investing involve going long volatility, which should be taken into consideration;
4) Hedge funds also engage in hybrid stock and bond strategies to "play" a company's capital structure, and as a consequence, longer-dated bond yields and credit spreads might also prove useful in explaining hedge fund returns.
These factors, though not exhaustive, represent an initial educated guess as to what kind of passive factors might explain hedge fund returns.
In a next step, we conduct a multifactor regression and optimize it to weed out factors with no or low statistical significance. For the exercise below, we have used the HFR Fund of Funds Composite Index for the period stretching from 1990 to 2005. The factors used in the chart below to construct the "model" for the index are:
1) The three-month U.S. dollar LIBOR rate;
2) The difference in the performance of the S&P 500 Index and the Russell 2000 Index, as a proxy for the difference in performance between large- and small-cap stocks;
3) The slope of the U.S. Treasury interest rate curve, measured as the yield differential between the two-year and the 10-year T-bond;
4) The returns generated by a mechanical covered call writing strategy on the S&P 500 Index, as represented by the Chicago Board Options Exchange's Buy-Write Monthly Index (BXM).
As can be clearly seen, the return path described by this model no longer significantly diverges from that of the HFR Fund of Funds Composite Index. The model gives an adjusted R-squared of 98 percent, even though we still observe some discrepancies in 1998 and in 2003. Armed with these findings, we can now postulate the following hypothesis: Hedge fund returns are made up in large part by passive market factors, even though one might not say that all such factors are plain vanilla in nature. Mind you, this analysis was conducted on the average hedge fund space, hiding the fact that some hedge funds actually deliver some alpha, while others are mere repackagers of all sorts of beta.
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