Taking Stock

Equity hedge fund strategies and portfolio choices

EXTRACTS FROM A REPORT BY BARCLAYS CAPITAL SOLUTIONS

The equity hedge fund segment is obviously fairly broad and includes a set of disparate strategies. We have taken a close look at these various sub-strategies, which each have their own unique characteristics and appeal to investors. We describe these sub-strategies in this article and attempt to show their performance and net new flows.

Equity HF AUM split by strategy
Fig.1 shows that while equity hedge funds overall have experienced AUM growth, the various sub-strategies within this segment have grown at different rates. The overall equities AUM CAGR was 12% between 2008 and 1H14, but the underlying sub-strategies fall into three different AUM growth categories:

  1. High growth: activist and multi-strategy;
  2. Moderate growth: long/short, sector-focused, market-neutral, and event driven;
  3. Slow growth: quant.

It is also interesting to note that only activist and event driven hedge funds appear to have an average AUM that is greater than the overall average AUM for all equity hedge funds.

Return and standard deviation by equity HF sub-strategy
Fig.2 shows that equity hedge fund sub-strategies had varying levels of losses in 2008 and have since had equally disparate levels of gains.

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For instance, equity market-neutral (EMN) and quantitative equity (quant) experienced the smallest declines in 2008, but have had the lowest returns recently. The other sub-strategies each had steeper declines in 2008 and have seen varying levels of recovery since then, as activist, event driven, and sector-focused strategies have been well ahead of fundamental long/short and multi-strategy, though recently these two sub-strategies have shown improved performance. It is worth pointing out that although the returns of the individual sub-strategies showed significant variation, from 2007 to 1Q14 each sub-strategy had a higher annualized growth rate than the S&P 500 (i.e., 4%) other than quant, and from 2011 to 1Q14, each sub-strategy had a lower return (i.e., the S&P 500 was19.3%). Similarly, the various sub-strategies’ annual standard deviations differed in absolute terms; however, the general direction has been the same across the board with consistent decreases since 2011. This is in line with the broader equity market, which has also seen lower volatility of returns.

Upside versus downside capture [1]
Most equity hedge fund managers we spoke with indicated that they seek to capture somewhere between two-thirds and three-quarters of the upside and one-quarter to one-third of the downside of the S&P 500.

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However, according to HFR data, equity hedge funds have been closer to 50:50 on both sides recently, as depicted in Fig.3. It appears that select equity strategies have captured more of the upside relative to the S&P 500 recently (i.e., from 2012 to 2013 versus 2007 to 2009), especially activist strategies (improved by ~70%). However, each sub-strategy also captured more of the downside over the same time period, especially long/short where downside capture increased by over 100% – potentially due to macro factors, stock selection and/or market timing challenges. Some of the sub-strategies, such as long/short, saw their 2012 to 2013 results improve significantly from 2010 to 2011, suggesting that they may be righting the ship. Event driven and activist also showed improvement as they exhibited the highest positive disparity between their upside and downside capture ratios.

Comparison of flows to AUM
Obviously investors did not allocate to various equity hedge fund strategies in a pro rata way over the last three years.

As Fig.4 shows, activist and equity multi-strategy hedge funds received a significant portion of recent net new flows (i.e., activist hedge funds received 41% and multi-strats received 47% of net new flows, respectively) despite collectively accounting for just over 10% of total equity hedge fund AUM. Activist, the strategy with the highest recent returns, as well as event driven, which was the recipient of the third-highest amount of net new flows, are strategies generally perceived as being less market-dependent and more catalyst-driven, which may explain why they were among the winners of net new flows. Investor sentiment may be changing though – long/short was the largest gainer in 1H14, winning ~33% of all net new flows to the equity hedge fund space.

EQUITY HEDGE FUNDS’ PORTFOLIO CHOICES AND THEIR IMPACT ON PERFORMANCE
In order to get an understanding of the strategic choices equity hedge funds have made that may have impacted their performance, we looked closely at return data across a large number of equity hedge funds in addition to our interview/survey data. Novus, a service provider (unaffiliated with Barclays) that provides industry intelligence to institutional investors and asset managers, was generous enough to share with us specific analyses carried out on their hedge fund database which consists of over 800 equity hedge fund managers. The total number of positions analysed was over 100,000 in number and added up to about $1.7 trillion of market value. The following sections highlight some of the key findings.

Portfolio construction and management
An analysis of the returns of the hedge funds in the Novus sample is shown in Table 1. Using the S&P 1500 as a benchmark, it is clear that the hedge funds in the sample had better returns over the last 10 years (9.4% versus 7.7%) in the aggregate than the S&P, though they did have a slightly higher annualized standard deviation also (16.5% versus 14.9%).

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Table 1 shows that, when we categorize the holdings of these hedge funds based on a number of different factors, the results are quite insightful. For instance, when you look at just the investments that account for 5% or more of a manager’s portfolio (i.e., ‘conviction’ positions) or investments where hedge funds have the highest proportion of a stock’s outstanding shares (i.e., concentration), both these types of positions significantly outperformed the S&P 1500 (>5% of annualized alpha in both cases). On the other hand, the most popular investments among the hedge fund managers in the sample (i.e., ‘consensus’ positions) and the largest overall investments (i.e., ‘size’ positions) for these managers either only achieved parity with or underperformed relative to the S&P 1500, while having a slightly higher annualized standard deviation in both cases. This suggests that hedge fund managers have benefited from taking positions based on their fundamental research and have been penalized for groupthink.

Market cap of holdings
Another factor we looked at was how the distribution of market cap of the stocks in hedge fund managers’ portfolios has potentially had an impact on equity hedge fund performance. In 2004, large and mega cap stocks represented only 40% of hedge fund investments in the Novus database. This proportion has gradually increased to about 57% today. This is possibly because many equity hedge funds have grown significantly in size, and investing in small cap stocks may be increasingly difficult for them. The difficulty that these hedge fund managers and their investors could potentially face down the road unfortunately is that at least in Q1 2014, the same hedge funds generated most of their alpha from their investments in micro and small cap stocks, and not from their larger cap holdings. If this continues to hold going forward, the trend toward holding larger cap stocks may be detrimental to equity hedge fund performance in the future.

Concentration of top positions
Just as there was a skew in the positions held by hedge funds in the Novus database toward smaller cap stocks relative to the S&P 1500, Fig.5 shows that these hedge funds also tended to hold more concentrated positions relative to the S&P 1500.

While this conclusion might seem trivial, we found that hedge funds in the Novus sample had almost 60% of their long equity AUM concentrated in their top 10 positions, whereas the S&P had far less concentration (at less than 20% – a difference of more than 40%). An analysis of the concentration levels and returns of the hedge funds in our sample shows that, at least for this group, the hedge funds with higher concentration levels among their top 10 positions had the highest levels of returns. In fact, the group that had 50% or more of their long AUM concentrated within their top 10 positions had twice the return of those that had 10% or less (i.e., 20% versus 10%, respectively). Although this seemingly goes against the mantra of diversification, the hedge funds we interviewed indicated they have robust risk management systems in place to help protect against potential downside losses should their top positions start to go south. It is also worth acknowledging that market conditions recently (i.e., in 2013) may have been particularly conducive to more concentration of positions being rewarded by the market.

Stop loss impact on returns
Another factor we wanted to examine was the potential impact on returns of using a strict stop loss methodology. In Fig.6A, we show the distribution of managers in our sample, based on whether and how they use stop loss methodologies (horizontal axis) as well as their 2013 returns (vertical axis). The chart shows that less than 20% of the hedge funds in our sample indicated that they follow a strict stop loss methodology[2] while the remainder were equally split between those that do some type of tiered monitoring (i.e., monitor and re-evaluate positions as each stop loss level is breached) and those that do not use stop losses to monitor their positions. The chart also shows that the respondents that either used tiered monitoring3 or never used stop losses actually performed better in 2013 relative to those hedge funds that strictly followed stop loss protocols. Looking at just the respondents that never used stop losses, the largest percentage of these managers had better than 20% average returns in 2013, whereas the largest segment among hedge funds in our sample that strictly use stop losses had less than 10% returns on average in 2013.

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Fig.6B shows the adoption of stop loss methodologies by sub-strategy among the equity hedge funds in our sample, along with their average 2013 returns. It is interesting that the average returns in 2013 of hedge funds in our sample went up significantly as we went from managers that strictly follow stop loss methodologies to those that prefer tiered monitoring, ending with the highest average returns accruing to those managers that never use stop losses – for instance, the range of performance improvement from ‘tiered monitoring’ to ‘never use’ was +20% for market-neutral hedge funds. It is interesting to note that the distribution of respondents by their use of stop losses was relatively consistent across long/short, quant, and market-neutral, while event driven was a significant outlier. Among these managers, 71% are more likely to never use stop losses than use either tiered monitoring (14%) or to strictly follow stop losses (14%).

Footnotes

  1. Upside/downside capture in a period is a measure of an investment’s compound return when the benchmark was up or down divided by the benchmark’s compound return when the benchmark was up or down, respectively.
  2. A stop loss limit is designed to limit an investor’s loss on a position in a security when a threshold is breached.
  3. Tiered monitoring refers to establishing different levels of manager attention for tiers based on cascading levels of loss.