Two months ago, when noting that hedge funds are about to underperform the market for the 7th consecutive year, we looked at the "why": "how do hedge funds manage to underperform the broader market for 7 years in a row? Simple: by shorting all the same stocks - thereby inducing massive short squeezes when just one is forced to cover [in an illiquid market], and going long all the same strategies, such as Growth And Momentum", known as clustering and "hedge fund hotels."
Actually the "why" is even simpler than that: as central planning has dominated every piece of fundamental news, and as capital flows trump actual underlying data (usually in an inverse way, with negative economic news leading to surging markets), the conventional asset management game has been turned on its head. We have said this every single year for the past 7, and we are confident that as long as the Fed and central banks double as Chief Risk Officers for the market, "hedge" funds will be on an accelerated path to extinction, quite simply because in a world where a central banker's money printer is the best and only "hedge" (for now), there is no reason to fear capital loss - after all the bigger the drop, the greater the expected central bank response according to classical Pavlovian conditioning.
But while hedge fund upside may be capped, downside is quite unlimited in this market where levered beta works great until suddenly a hedge fund hotel, such as Valeant, blows up and wipes out dozens of "smart money" investors. Recall what Goldman said yesterday: "hedge funds own roughly 22% of Valeant’s shares, so investor sentiment and perceptions matter; our Hedge Fund Trend Monitor indicates that 7% of fundamental hedge funds own shares in VRX with 5% owning it as a top 10 position."
All of the above should have been obvious and rather very intuitive, however hedge funds - the biggest losers from the above assessment - have understandably been eager to ignore this "New Normal" reality. Alas, as long as global central bank put is in play, it makes all of them obsolete.
Following their latest underperformance, it is no longer possible to ignore the obvious: in the year in which central banks will unleash the greatest amount of liquidity in the "markets" in history, and where we have seen at least 77 easing steps taken by global central banks, hedge funds are poised to record their worst performance since 2011, according to JPM.
Here are the highlights:
- Relative to a bond/equity portfolio benchmark, with weights chosen to reflect the relative distance of bond and equity volatility from that of HFs, HFs underperformed by -1.7% YTD.
- It is not only that HFs appear to have delivered a negative alpha for a second year in a row, the properties of both their cross sectional and time series return distributions have been also disappointing.
- It is the first time since 2011 that the portion of the HF universe delivering returns of less than -10% YTD is larger than the portion of HF returning above 10%.
- The skewness of HF daily return distribution so far this year has been more negative and its kurtosis higher than that of either bonds or equities.
- By looking at their skewness and kurtosis combined, HFs have not only delivered worse convexity than last year but they appear to have delivered the lowest convexity since 2011.
- It is ironic that the HF categories that have suffered the most, Event Driven and Equity Long/Short, were the ones which together received the highest inflows YTD.
- The relative growth of Equity L/S and Fixed income-based Relative Value Arbitrage, which represent the highest HF sectors in terms of AUM, indicates higher appetite by investors for Relative Value strategies
Hedge funds saw the largest quarterly AUM decrease since the Lehman crisis during the past quarter, according to the release of the Q3 HFR report. The AUM of the HF universe declined by $95 bn to $2.87tr, mostly due to almost a negative 4% return on the quarter. There was little offset by capital flows as only $5.6bn entered the HF industry in the quarter. This compares to inflows of close to $20bn per quarter in the first half of the year, showing how negative the impact of elevated volatility of the third quarter was on overall HF flows. In fact volatility had exhibited higher correlation historically with HF capital flows than HF performance. The historical correlation between the VIX and net HF capital flows has been -0.90 since 2008, relative to -0.41 between the VIX and the AUM reduction due to performance (Figure 1)”.
More on the underperformance issue: "The portion of the HF universe delivering returns of less than -10% (through September) has been larger YTD than the portion of HF returning above 10%."
In other words the cross sectional distribution of HF returns has been rather disappointing this year. In fact Figure 3 shows that it is the first time since 2011 that the cross sectional distribution is negatively skewed, i.e. it is the first time since 2011 that the portion of the HF universe delivering returns of less than -10% is larger than the portion of HF returning above 10%.
Perhaps it is a moot point in the aftermath of the Fortress Macro fiasco, but it is worth noting that Macro HF beta to the S&P is now the lowest it has been in years, suggesting that the recent surge in the S&P500 will be largely lost on precisely the group that has underperformed the most.
Sure enough, macro hedge funds continued to bleed with outflows of $5.1bn in Q3, led by CTAs, despite better performance both in Q3 and YTD relative to Event Driven or Equity L/S. Continued aversion of investors towards the Macro HF sector meant that Macro HFs represent the smallest of the four major sectors with an AUM of only $543bn as of Q3.
And the rest of the observations:
- There has been noticeable divergence across the main four HF sectors: Event driven, Macro, Equity Long/Short and Fixed Income Relative Value.
- Equity L/S funds saw the worst performance of -5.9% in Q3. Despite this, they saw $2.4bn of inflows in 3Q and $23.8bn YTD. Event driven was the HF category that also suffered heavily in Q3. Event Driven HF returns are typically explained by equity and credit spread returns. Both asset classes suffered over the past quarter creating a bad mix for this category of hedge funds. Despite very negative performance Event Driven funds, received $5.4bn of inflows in Q3.
- YTD they received $11 bn through September, bringing total AUM $745bn.
- It is ironic that the HF categories that have suffered the most, Event Driven and Equity Long/Short, were the ones which together received the highest inflows YTD. Equity L/S is the largest HF sector, managing $808 bn as of Q3.
- Fixed income-based Relative Value Arbitrage follows with the second highest AUM of $777bn as of Q3. These Fixed income-based Relative Value Arbitrage funds saw inflows of $12.2bn YTD. Their performance was roughly flat YTD through September.
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And now all eyes on tomorrow's critical defense by Valeant: if the company fails to dispel all concerns that it is a fraud, the pain for hedge funds may only accelerate from here: after all at last check, VRX was the 10th most popular stock among the hedge fund community as of June 30.