With AAPL and several other strange-attracting hedge fund hotels dominating the holdings of the 2-and-20'ers, we thought it timely that Bloomberg TV [6] would point out today that their aggregate hedge fund index is now significantly underperforming the S&P 500 (from both the top in 2007 and the lows in 2009 - in order to be fair). While the assumption is that 'sophisticated' investors are paying for alpha - and as always the focus is absolute return on the way up no matter what the mandate - it seems the extreme correlations both across asset-class and within-and-across individual equities (as we have discussed in depth - most recently here [7]) have indeed eaten into any 'value' that has empirically been added. As The Economist notes [8], in June "funds suffered the largest withdrawals in assets since October 2009." Furthermore, as Citi's recent study on risk drivers shows, the high-beta momentum trade has become by far the most crowded trade around - so even sales of DB9s and NYC apartments are now entirely dependent on NEW QE coming before year-end.
Hedge fund aggregate returns (Bloomberg and HFRX indices) have notably lagged the S&P 500...
[9]
Citigroup uses short interest as a way to assess the "crowdedness" of factor exposures. The chart below shows the rank correlation between the short interest ratio, defined as short interest outstanding divided by shares outstanding, and long-term price momentum. This analysis is based on the Russell 1000 universe. As this correlation becomes more negative, it signals that the factor is becoming more crowded. That is, an increasingly negative rank correlation indicates that there is more short interest in low momentum stocks and less short interest in high momentum stocks, suggesting a growing consensus regarding momentum. Currently, this analysis suggests that the long term price momentum factor is becoming VERY crowded.
and as The Economist [8] notes:
There are lots of claims, and counter-claims; in this area; lots of studies that try to account for factors such as survivorship bias and volatility. But a few things seem pretty certain.
- Many hedge fund managers are smart, and some managers may be a lot smarter than the average investor. The difficulty is in identifying those investors in advance.
- There are some generally uncorrelated strategies but these niches can be quite small, and consist of illiquid assets. As a result, the lack of correlation with the big asset classes may be partly caused by the slowness of price adjustment in such assets, since deals are less common. But the corollary is that it is difficult to exit such strategies in a crisis, with the result that there are occasional steep drops in valuations.
- For the bulk of the industry there is likely to be a reasonable correlation with indices such as the S&P 500. As the industry gets larger, this correlation is likely to increase and it will be harder for the average manager to outperform.
- Hedge fund managers will thus be subject to the same constraint as mutual fund managers; that returns are equal to the index minus costs. And since their fees are higher, the result will be disappointing returns for the average investor.
Source: Bloomberg, Citigroup