The Bright Side of Hedge Fund Returns

The benefit of investing in hedge funds is rightly being questioned after delivering lack-luster performance in 2011. According to Hedge Fund Research, global hedge fund returns in 2011 were -8.87%, nearly a double-digit loss relative to the return of the S&P 500, which was flat for the year.

What should not be overlooked, however, is that in 2011, despite the ongoing turmoil in global credit markets, hedge funds continued to deliver on one of their core strengths: returns that are less volatile than the stock market. Comparing monthly returns of the Hedge Fund Research Global Hedge Fund Index (HFR) to those of the S&P 500 makes this clear:

The big story in 2011 is that while hedge funds guarded investors against September lows, they missed out on the rally in October. One way to look at hedge funds' low volatility is to view the funds as being--contrary to popular wisdom--generally cautious, as they continue to be in the first month of 2012. 

And 2011 was not a fluke. Any broader time period makes it even more clear that hedge funds are less volatile than stock markets, as the following graph demonstrates for 2009 to 2011:

Low volatility is generally good because volatility reduces returns in the long run. But low volatility is not an end-in-itself since investors ultimately care about risk-adjusted returns. Low volatility means little if returns turn out to be negative, as they were in 2011.

So perhaps a bit less caution is in order.

Comments

[KingD]

how do you address the selection bias inherent in hedge fund indexes?

[Adithya]

In addition to selection bias, there is a lot of evidence on autocorrelations that cause hedge funds to be less volatile than they actually are. There is a great article called: "Do Hedge Funds Hedge" in the Journal of Portfolio Management which addresses these head-on (they use the TASS/Tremont index rather than HFR....but you can show the same effect with both): http://faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investments/asness_crail_liew_hedge_funds_hedge_JPM.pdf

[Houman Shadab]

Thanks for the comments. Raw monthly reported returns certainly have their limitations in showing how volatile hedge funds are, due to return smoothing and other reasons.

However, more recent and comprehensive empirical research indicates that, even after controlling for backfill and survivorship biases, more actively managed funds are indeed less volatile (have higher Sharpe ratios). See Titman and Tiu's 2010 article, "Do the Best Hedge Funds Hedge?", here:
http://rfs.oxfordjournals.org/content/24/1/123.full.pdf

[Trading on line]

"Low volatility means little if returns turn out to be negative, as they were in 2011."

That's the most important phrase in the entire post and it pretty much sums everything up.
2011 should definitely be a lesson to all of those who are planning on investing in hedge funds this year.

[domain name search]

Thanks for the comments. Raw monthly reported returns certainly have their limitations in showing how volatile hedge funds are, due to return smoothing and other reasons.

However, more recent and comprehensive empirical research indicates that, even after controlling for backfill and survivorship biases, more actively managed funds are indeed less volatile (have higher Sharpe ratios). See Titman and Tius 2010 article, Do the Best Hedge Funds Hedge?, here:
http://rfs.oxfordjournals.org/content/24/1/123.full.pdf
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