I got a spate of questions regarding Bridgewater Associates ‘s performance this year. For those who are not familiar, Bridgewater is the largest hedge fund in the world founded by Ray Dalio. And as of 2018, it manages more than USD 120 billion. In case you are wondering, I am not from Bridgewater and I never worked a day there. So why in the world am I asked these questions? Well, you see, these questions came from Quora. And people pretty much just shoot off the cuff, whether questioning or answering, without any checks or inhibitions. It is both the beauty and drawback of the platform.
Anyway, I digressed. My focus for this post is not so much on Bridgewater or Ray Dalio, but more on the perspective of the people posing the questions. One asked how Bridgewater did so well in 2018 and another asked why Bridgewater lost in the first half of 2019? Both, I infer are referencing against the US markets. To give you more color, Bridgewater’s Pure Alpha fund was up near 15% in 2018 but fell about 5% in the first 6 months of 2019. This sharply contrasts against S&P 500 which was down 6% in 2018 and up 17% in 1H 2019. These innocent questions reflect how some people, in particular, layman, look at hedge funds. Everyone knows what the S&P 500 is, but not everyone knows what hedge funds are or do. But yet, when it comes to comparison, it is almost always hedge funds vs S&P 500.
When we compare, as far as possible, we want to look at things objectively. So apples to apples, oranges to oranges. I don’t think anyone disputes that. So let’s see what we are comparing against.
What Is S&P 500?
The S&P 500 is a market capitalization-weighted stock index comprising 500 large companies listed on the NYSE and NASDAQ. For inclusion, the company must satisfy a range of criteria from size, liquidity, domicile to sector classification and more. However, in terms of composition, it might be less diversified than what most people thought. At the point of writing, the top 50 companies already account for more than 50% of the entire basket.
And in terms of sector concentrations, this is what it looks like.
The top 3 of the 11 sectors make up close to half the index. Information technology dominates at 22%. But you might want to know that giant internet company such as Facebook, Google, and Twitter fell under communication services. So if you consider this, this index has a fairly strong skew towards internet and technology-related stocks.
Hence, when you use the S&P 500 as a benchmark, you are comparing against the performance of a basket of US large-cap stocks that has a strong overweight on tech.
Now, what about hedge funds?
What Are Hedge Funds?
I have written on this in more detail before. You can read it in one of my older posts. But in a nutshell, hedge funds are specialized actively managed investments restricted to a niche group i.e. institutions and the rich. In return, they are lightly regulated and given wide latitude to pursue all kinds of strategies across different asset classes globally. Many do not run your traditional long-only strategies and neither are they stock-only funds. So what do these guys do differently?
To see the top-level picture, I pulled some data from Barclayshedge (data as of 1Q 2019). The pie chart below shows you the distribution across USD 3.2 trillion worth of assets managed under different hedge fund strategies.
As you can see, the hedge fund asset and strategy landscape are pretty diverse. There are many ways you can cut it, but this is how Barclayshedge categorizes them. Hedge funds can dabble in any asset class — equities, fixed income, FX, commodities, etc. They can short-sell, take on high leverage, trade derivatives, place concentrated bets, deploy sophisticated arbitrage strategies and more. The limit is your imagination. A good bulk of what hedge funds do are fairly uncorrelated to the markets.
While equity managers may form the largest chunk, the closest match to the S&P 500 is the Equity Long-Only slice which is only 4% of the entire hedge fund assets. And among this 4%, not all are US equities. Even if it is predominantly US, the question of whether or not it is skewed towards large-cap or the tech sector remains. Thus, to take the hedge funds as a group and compare it against the S&P 500 or any other equity index does not make a lot of sense here. It is like comparing the score of your Math exam against another’s English exam, and then determining who is better than the other.
Why Do People Compare Hedge Funds To S&P 500?
S&P 500 is everywhere
It is readily accessible with many liquid investable products based on it such as mutual funds, ETFs and futures. So there is a natural tendency for people to see S&P 500 as a base case. They are not looking at evaluating a hedge fund objectively against what it is supposed to do. Instead, they view it from the angle of opportunity cost. If I park my money into hedge funds instead of S&P 500, am I better off or worse, and by how much?
Return is still king.
History is littered with evidence of people chasing after returns often without understanding or underestimating the risks involved. Greed and fear of losing out are prime motivators. That’s why massive bubbles form and spectacular crashes follow. In the case of S&P 500, it performed phenomenally well after the subprime meltdown in 2008. And we have to thank the central banks worldwide for diligently printing cheap money for this. Now, we are in the midst of the longest bull market in history. Over the past 10 years, S&P 500 rose more than 300% since bottoming in 2009. Hedge funds, on the other hand, put up a mediocre performance, delivering under 80% as a group over the same period. This glaring difference became one of the most talked-about subjects among hedge fund critiques and the media.
But was this always the case? Did hedge funds persistently disappoint in terms of absolute returns?
Return Profile of Hedge Funds Vs S&P 500
Hedge funds did not always underperform. In particular, before 2008, hedge funds were the king. Money was pouring in and new funds sprouted everywhere. The industry grew rapidly from a little over USD 200 billion in 2000 to more than USD 2 trillion in 2008 before the crisis hit.
To get a more complete picture, let’s see how hedge funds and S&P 500 did both during good and crisis periods. Unfortunately, I do not have the monthly performance data from Barclayshedge. So I will be using data from another provider instead — HFRI. It stretches further back to 1990. However, different providers have their own way of slicing and dicing the hedge fund universe. So you will not see the exact same groups as Barclayshedge. But, it is not that important here. All we need is the big picture.
Selected HFRI Indices
And for this purpose, I will use the following groups from HFRI:
- HFRI Fund Weighted Composite — This is an equal-weighted index of more than 1400 hedge funds from all categories (excluding fund of hedge funds). It represents the aggregate performance of hedge funds.
- HFRI Equity Hedged — This index comprises managers primarily investing in equity. They can use a range of strategies from quantitative to fundamental, longs and/or shorts, diversified to concentrated, activist to passive, short to long term, etc.
- HFRI Event-Driven — This index comprises managers that employ strategies capitalizing on a range of corporate events such as mergers, restructurings, distress, share buybacks, share issuance, capital structure changes.
- HFRI Macro — This index comprises managers who structure their investments based on broad economic themes. They can use any method to derive their decisions and they invest globally across different asset classes.
- HFRI Relative Value — This index comprises managers that capitalize on the deviation of pricing relationships between different securities across various asset classes.
HFRI Hedge Fund Inclusion Criteria
For your information, hedge funds under HFRI need to satisfy the following:
- At USD 50 million in size
- Operated longer than a year
- Open to new investment
- Returns reported are net of fees, expenses and in USD (in line with S&P 500)
- All funds are equally weighted at the start of the calendar year
Hedge funds did better on a relative basis during every single crisis since 1990. They either lost less than the S&P 500, or in a few instances, even delivered positively. Is that surprising? No. As mentioned, most are not your typical long-only and equity-only funds. These funds collectively pursue a spectrum of different strategies across multiple asset classes globally. Hedge funds’ main value lies in providing an uncorrelated stream of return against traditional markets.
Bull Market Performance
Under most circumstances, hedge funds lag behind S&P 500 during bull periods. And is that surprising? Again no. Lower risks often come at the expense of lower returns. Before I join the industry, I use to think that hedge fund managers are all bold risk-takers who are so good with the market that they always get it right ahead of time. So when markets turn up, they are already positioned long. And before markets head south, they flip and short. This simple picture could not be further from the truth. Good hedge fund managers are normal human beings like you and me. They don’t have a crystal ball and they are far from being always right. But they do know what they are good and bad at. And they know how to capitalize on their strengths and manage their weaknesses.
If we take the entire period from 1990–2019, hedge funds still deliver more returns than the S&P 500. However, most of it was made prior to 2008.
Hedge Funds Is Not Some Invincible Investment Solution
Every hedge fund has its specific strategy and comes with its baggage of shortcomings. Macro trend-following funds do well when there are clear and extended trends, but suffer when markets swing wildly in either direction. Statistical arbitrage funds experience distress every once in a while when pricing relations diverge way beyond their expected norms. Risk parity type funds depend on the low correlations between different asset classes to hold. But when correlation breaks down and everything moves south in tandem, losses can swell. Dedicated short bias funds or long volatility funds can die a slow bleed in an exceptionally long bull and low volatility environment. Short volatility funds are susceptible to huge losses from a sudden surge in volatility like what happened in February 2018.
To cut the long story short, holy-grail funds do not exist. Investors need to know exactly what they need and look specifically for the hedge fund that can fill up this gap. For example, a well-diversified but long-only investor may be looking for protection against market shocks. So he might sacrifice some upside to allocate capital to good funds specializing in tail-hedge strategies e.g. long volatility or dedicated short bias.
While the edge hedge funds once have seems to have tapered off, and selecting good funds are now more challenging with a lot more funds swarming the markets, much of the underlying premises behind these strategies remain sound. So, rather than look at hedge funds and S&P 500 as irreconcilable competitors, they can in fact complement each other.
Ending This Off With Bridgewater
I started this post talking about BW Pure Alpha Fund and some of you might be wondering what they did to become the world largest hedge fund. So I will end off with showing how they fared since inception against S&P 500. To sum it up, higher return, lower volatility, lower drawdown, and all this with a low beta against S&P 500. Of course, this is not the only factor contributing to their success, but is nevertheless, one of the crucial ones.
Note: I am not associated with Bridgewater. All these are purely for information.
Originally published at https://investmentcache.com on August 22, 2019.