This Tuesday, the Wall Street Journey runs a story of hedge funds caught on the wrong side of a ‘can’t miss’ trade. We know that certain trades hardly exist and in this case it was no less than a wrong view on the future. Many hedge funds acquired large chunks of debt of troubled energy companies, hoping for a rebound in oil. Currently the oil price has yet to recover, leaving the hedge funds with bleeders in their portfolio. Naturally, not all hedge funds are in this trade. However, according to HFR, during the third quarter total global hedge fund capital posted the largest decline in capital since the Lehman-collapse. Across all strategies, total fund capital declined with USD 95 billion to end at USD 2.87 trillion.
The performance of the ‘hedgies’ was also poor: the HFRI Fund Weighted Composite Index dropped with 3.9% during the quarter. Year-to-Date, the performance turned negative to minus 1.5%. Still, this is much better than the broader US stock market. The S&P 500 showed a performance of minus 6.7% during the first 9 months of 2015. But should we really compare hedge fund performance with the S&P 500? Hedge funds generally are meant to generate alpha or an absolute return. This means their strategies should not be affected by negative of positive market developments. Furthermore, these funds should look beyond the US stock market. When compared to a global equity ETF, the iShares MSCI World ETF (-5.7%), hedge funds showed a significant outperformance. However, the most liquid US Treasury ETF, the iShares 20+ Year Treasury Bond (TLT) showed a performance of -0.2% and thus beat the hedge fund managers.
Interestingly, despite the poor performance, overall investors poured more money into this asset class. According to HFR, net inflows amounted USD 5.6 billion in the third quarter. With a number of major events (Greek crisis, Dieselgate), ‘event-driven’ funds saw USD 5.4 billion inflow. Remarkably, these funds were not able to capitalize market reaction and lost USD 5.1% in Q3. Equity strategies saw the most inflows this year: + USD 23.8 billion. But once more, these funds couldn’t not mimic the MSCI World and even booked a loss of 2.3% during the first nine months of 2015. It looks like most LatAm hedge funds were long, since they showed the worst performance with a loss of 20.2%. Also energy-dedicated funds were caught on the wrong side of the trend and lost 12.4%. Not surprisingly, exploiting volatility was the best performer with a plus of 5.5%.
The figures show how difficult it is to have a working absolute return strategy, i.e. a strategy that always delivers a positive result under all market circumstances. For diversification it may be not the best idea to take a global benchmark of hedge funds. Equity strategies could prove even more difficult to blend in due to the variations, despite the fact the outperformance over S&P500 and the MSCI World. Volatility is an interesting category, since when global investment risk rises, this mostly is accompanied by higher volatility in financial markets. The other side of the medal is that this category will be a huge dog in long bull runs. So probably the fact that most hedge funds are only available to professional investors, is not a troubling issue for private investors.