In this article, we explore what factors have been driving the recent poor performance in long/short funds. We focus on two subgroups of these funds-long bias (directional funds) and no bias (non-directional funds). We find that these funds' underperformance in recent months can, in large part, be attributed to declines in well-known systematic sources of return and risk.
Generally, we find that:
The poor performance of directional funds has been due in part to:
– US stocks with high earnings variability
– European stocks with low yields
– European growth stocks
– European small caps
– Emerging markets
The poor performance of non-directional (or market neutral) funds has been due in part to:
– US stocks with low leverage
– US stocks with high earnings variability
– European stocks with low yields
– European small caps
In the last few months, many long/short hedge funds have experienced negative returns, extending a decline which began in the middle of last year. While some fund categories such as convertible arbitrage and event-driven funds have remained resilient in the last year, others have not fared as well. In just the last month, both directional and non-directional (i.e. market-neutral) funds have experienced significant losses. Table 1 puts these declines in context.
Given these declines, what factors appear to be at work? We analyze the performance of a sample of funds using a returns-based model, which maps the returns of individual hedge funds to both well-known systematic factors (including market, industry, and style factors) as well to strategy factors that are relevant for each fund's peer group. The full details of the model are laid out in Alvarez and Levinson (2007)i.
Because hedge funds rarely make available their holdings, hedge fund risk models must rely primarily on returns. As with any returns-based analysis, identifying systematic sources of risk is made more difficult by the presence of noise in the return series. In addition, exposures to sources of risk are rarely constant, in particular, for hedge funds managers who are likely to change their strategy depending on their market outlook.
Lastly, identifying those factors which are relevant for hedge fund returns can be very difficult; especially when hedge funds expand their holdings into quasi-equity and fixed income instruments, such as structured products.
To measure the influence of suspected drivers of recent hedge fund performance, we rely on a dynamic returns-based model. The model is based on the state space (or dynamic linear) modelii that is capable of capturing time-varying exposures to factors driving return over time. Dynamic exposures are warranted in those cases when hedge funds are rapidly changing their factor exposures over time. The recent crisis in equity and bond markets is likely to have caused hedge funds to alter their risk exposures so the following analysis makes use of the state-space modeling methodology.
The recent declines in Long Bias funds appear to be driven by biases toward the following Barra factors: positive exposure to US and European markets, positive exposure to the US Earnings Variability Factor, negative exposure to the European Yield Factor, positive exposure to the European Growth Factor, negative exposure to the European Size Factor, and slightly positive exposure to emerging markets. Table 2 shows the factorsiii we identify as important to the significant declines in long bias funds ranked by importance. Average exposures to the factors over the time period are also shown.
What the results suggest is that, on average, long bias funds were taking directional bets towards European markets while only slightly long US markets. They were also, as a group, long European growth stocks and stocks in the US with high earnings variability. These bets constituted a large portion of the poor performance of Long Bias funds overall, though individual funds may have been differently impacted. But depending on the degree of leverage for each fund, the impact from these simultaneous down-movements could be dramatic.
To get a sense for how these exposures shown above evolve over time, we next plot the exposures of the MSCI Long Bias Hedge Fund Index to the relevant factors. This is shown in Figures 1 and 2 beginning in 2007. These figures suggest several possible trends during the observed period:
Meanwhile, no bias or so-called "market-neutral" funds have been hurt by positive exposure to US and European markets, negative exposure to the US leverage factor, positive exposure to the US earnings variability factor, negative exposure to the European yield factor, and negative exposure to the European size factor. In contrast to long bias funds, non-directional fund exposures to emerging markets and the European Equity Growth factor are quite insignificant. Instead, these funds appear to have been hurt by exposure to US stocks with higher than average leverage. Interestingly, an important factor that has helped offset some of the losses for no bias funds is the US equity short-term momentum factor. The index's overall negative exposure to this factor suggests that the funds may have captured some of the short-term reversal in the market, which was helpful in stemming some of the market losses during the August crises.The fact that no bias fund performance has been eroded by overall exposure to the US and European markets is surprising. On one hand, no bias funds appear to have been less exposed compared to the long bias funds, as we would expect. On the other hand, these exposures are still not indicative of true market neutrality. A number of explanations are possible. For instance, market forces (i.e., the assumptions for correlations and volatilities used to create the hedge) may have unexpectedly moved against these funds. Or alternatively, short positions in Asian stocks may have implied a bias towards European and US markets depending on the portfolio construction method, for instance, global-sector-based hedging programs.
Commentary
Issue 36
A Rough Start to the Year for Long/Short Funds
A look at systematic drivers of return
MIGUEL ALVAREZ, JENNIFER BENDER & MIKE LEVINSON, MSCI BARRA
Originally published in the April 2008 issue