TheEdhec Alternative Indices

EDHEC's "index of indexes" - the January 05 and February 05 overviews

Edhec Risk and Asset Management Research Centre

The month of January was characterised by poor stock market performance, the end of the decrease in credit spreads, and historically low levels of stock market volatility. Bond performance was also mixed, with notably negative returns on the high yield segment. In this relatively unfavourable environment, all hedge fund strategies except for emerging markets and short selling fell short of their long-term average performance. This is particularly true for directional strategies (e.g. Long/Short Equity, Global Macro, CTA Global) and Convertible Arbitrage, which even posted negative returns.
 

Convertible Arbitrage

Convertible Arbitrage funds achieved returns of -0.90% over the month of January, which is way below their historical average. This negative return might be explained by the extremely low level of stock market volatility – i.e. the lowest since November 1995 – declining equity markets and sluggish bond markets. The stabilization of the credit spread after a 4-month trend of spread narrowing also contributed to this bad performance (i.e. the worst since June 2004).

CTA Global

After a good year-end, CTA managers posted a strongly negative return in January (-1.95%). CTA is therefore the worst performing strategy this month. This performance was obtained in spite of bearish stock markets and booming commodity markets, which are typically favourable to CTA managers. The low level of stock market volatility and currency reversal appear to be the main factors driving this poor performance.

Distressed Securities

Distressed Securities funds returned 0.40% in January. The declining stock markets and the extremely narrow spread between small caps and large caps significantly hampered the performance of Distressed Securities funds this month. The stabilization of the credit spread after a 4-month trend of spread narrowing also contributed to this poor performance. Fortunately, stock market volatility remained at historically low levels and the credit spread was particularly narrow, preventing Distressed Securities funds from achieving even more disappointing performance. Nevertheless, it should be noted that for the 8th consecutive month, these funds posted a positive return.

Emerging Markets

Emerging Markets hedge funds posted a return of 1.03% in January, allowing Emerging Markets funds to obtain their 6th positive performance in a row. This is all the more impressive in that Emerging Markets funds succeeded in beating their long-term average return despite relatively unfavourable stock and bond market environments.

Equity Market Neutral

Equity Market Neutral funds showed sound returns of 0.73%. This performance is roughly equal to the historical average, even though it was clearly hampered by extremely low levels of implied volatility and the particularly narrow small cap/large cap spread. However, the low level of credit spread (i.e. the lowest since February 2000) and the flattening of the yield curve (i.e. the flattest since August 2001) came as good news for managers in this strategy.

Event Driven

Event Driven funds posted a disappointing 0.18% return in January. The declining stock markets, the tight spread between small caps and large caps and the end of the decrease in the credit spread explain this poor performance. Low levels of credit spread and implied volatility could only prevent Event Driven managers from posting a negative return. However, it is worth noting that this is their 6th positive return in a row.

Fixed Income Arbitrage

Fixed Income Arbitrage funds showed returns of 0.49%. This performance is roughly equal to the historical average, and is the 18th consecutive positive performance for the strategy. This performance was obtained in a context of low volatility and narrow credit spreads, which are typically favourable to Fixed Income Arbitrage managers. The flattening of the yield curve prevented Fixed Income Arbitrage managers from beating their long-term average return.

Global Macro

Global Macro funds posted a disappointing -0.38% return in January, putting an end to a series of positive returns. Macro managers suffered from negative returns in the equity markets and the mixed performance of the bond markets. They also had to make do with a narrow spread between small caps and large caps and a stabilization of the credit spread after 4 months of decline. Low volatility and narrow credit spreads in both these markets could only help them reduce their losses.

Long/Short Equity

Long/Short Equity funds posted a disappointing -0.53% return in January, putting an end to a series of positive returns which started at the end of Q3 2004. The falling equity markets together with the tight spread between small caps and large caps and the end of the credit spread down-trend strongly affected the performance of Long/Short Equity funds. The low level of volatility and the narrow credit spread could only help them limit their losses.

Merger Arbitrage

Merger Arbitrage managers posted a disappointing return of 0.06% on average in January. In addition to the decline in equity markets and increasing short-term interest rates, the spread between small caps and large caps, though positive, remained extremely narrow, contributing to the poor performance of Merger Arbitrage funds. The flattening of the yield curve together with the low level of volatility and the narrow credit spread only allowed them to remain in the black. They therefore succeeded in posting a positive return for the 6th month in a row.

Relative Value

Relative Value hedge funds posted returns of 0.12% in January. The poor market conditions were the principal determinant of this low return.
 

Short Selling

With a return of 3.35%, short selling is the top-performing strategy in January. This does not come as a surprise, as they typically take advantage of market declines. This excellent performance puts an end to a series of 4 negative monthly returns.

Global Outlook

The month of February was characterised by sound stock market performance, while stock market volatility maintained its historically low levels. February was particularly favourable for growth and small-cap stocks. The conditions for the bond markets were less favourable with increasing short-term interest rates leading to a drop in bond prices. Against this backdrop, most strategies have returns that are above their historical averages. Unsurprisingly, directional equity-based strategies performed particularly well. Convertible Arbitrage is the only strategy that has negative returns for the month of February.

Convertible Arbitrage

Convertible Arbitrage funds posted returns of -0.59% for the month of February. This negative return comes despite the strong equity market performance and may be due to low levels of short-term interest rates

CTA Global

CTA managers had flat performance over the month of February, with returns of 0.02% on average. Low volatility and low bond returns certainly hindered the performance of these managers. Against the backdrop of a steep rise in commodity prices, however, investors may have expected a better outcome for this strategy.

Distressed Securities

Distressed Securities funds returned 1.32% in February. This good result does not come as a surprise as the positive stock market performance and low volatility, as well as the good performance of small-cap stocks, meant very favourable conditions for managers following this strategy.

Emerging Markets

Emerging Markets hedge funds posted a return of 3.44% in February, which makes them the best performing strategy for this month. This result was facilitated by a stock market environment that was very friendly in general, and for small cap stocks in particular. The low levels of implied volatility over this month were also favourable to emerging markets hedge funds.

Equity Market Neutral

Equity Market Neutral funds showed sound returns of 0.86%. This performance is slightly above the historical average. The performance comes against a favourable backdrop of low and decreasing levels of implied volatility and the good performance of small-cap stocks and the stock market in general.

Event Driven

Event Driven funds posted returns of 1.54% over the month of February. This result was supported by positive equity market returns and low levels of credit spread and implied volatility, which meant favourable conditions for Event Driven managers.

Fixed Income Arbitrage

With a return of 0.91% in February, Fixed Income Arbitrage funds yielded a return that is significantly above the historical average. This strong performance can be explained by very low levels of volatility in both the bond and stock markets, which are typically favourable to these managers.

Global Macro

With a return of 1.83% Global Macro managers achieved sound performance over the month of February. This is mainly due to the positive conditions on the stock market. It should be underlined that Macro managers were able to achieve this performance in spite of less favourable conditions in the bond market.

Long/Short Equity

Long/Short Equity hedge funds posted a high return of 1.95% in February. This was achieved in an environment of very favourable conditions for managers in this strategy, as characterised by low levels of short-term interest rates, as well as the term spread and the credit spread, together with positive equity market conditions.

Merger Arbitrage

Merger Arbitrage managers posted returns of 0.61% on average in February. This result is slightly below average and may be surprising given the friendly equity markets, low levels of short-term interest rates and low spreads in the bond market (credit spread and term spread) which usually represent positive news for these managers

Relative Value

Relative Value hedge funds only posted average returns of 0.83% in February, in spite of largely favourable conditions with low credit spreads and high stock returns, as well as low levels of implied volatility.

Short Selling

With a return of 1.51%, short selling hedge funds achieved surprisingly good results given the positive stock market conditions. yield segment. In this relatively unfavourable environment, all hedge fund strategies except for emerging markets and short selling fell short of their long-term average performance. This is particularly true for directional strategies (e.g. Long/Short Equity, Global Macro, CTA Global) and Convertible Arbitrage, which even posted negative returns.

 


Explanatory note

What are the Edhec Alternative Indices?

The Edhec Alternative Indices use factor analysis techniques to provide the best possible one-dimensional summaries of the information conveyed by the competing hedge fund indices that are currently available on the market. Therefore, they can be thought of as a set of hedge fund indices providing a cross section of existing indices for each hedge fund strategy.

Why did Edhec set up its Alternative Indices?

Edhec's research on hedge fund indices led to a number of observations about the existing commercial indices, which included concerns over their transparency, independence, accuracy and timeliness. In addition, they cannot be expected to be fully representative of the hedge fund universe because the typical database only contains a small fraction of that universe. The data included is also subject to a certain number of biases:
 

  • Self-reporting bias: databases do not include funds that do not wish to be included – the index is not therefore likely to be exhaustive
  • Survivorship bias: the fact that onlysurviving funds are included artificially boosts the returns
  • Selection bias: the index providers have database inclusion criteria that can be very diverse
  • Instant history bias (or backfill bias): it is reasonable to believe that the funds will only decide to publish their results when they are at their highest levels. It is therefore probable that the average performances displayed by the funds during their incubation period will be better than those of funds that have belonged to the database for a longer period.
  • Style bias: most index providers rely on managers' self-proclaimed style classification. Misleading information and/or style drift may lead to the inclusion of funds that follow different styles in the same style category.

The different indices available on the market are constructed from different sets of data, according to diverse selection criteria and methods of construction, and they evolve at differing paces. One merely needs to examine the differences in monthly returns for the same strategies in differing indices to see the effects of this heterogeneity. As a result, investors cannot rely on competing hedge fund indices to obtain a "true and fair" view of hedge fund performance.

What is the point of indices if hedge funds seek absolute returns?

While hedge fund managers often discard the use of an index with reference to their "absolute returns" approach, the gradual institutionalisation of alternative investments and growing demand from institutional investors have led to a need for information on the returns of hedge fund strategies. Hedge funds actually exploit the many dimensions of risk in financial markets in order to expand the risk-taking opportunities of investors to a large variety of risk factors and to non-linear exposure. Indices are a convenient way of assessing the risk/return characteristics of such vehicles.

Why are Edhec's Alternative Indices better?

Edhec uses Principal Component Analysis to extract the common factor in the returns information for the set of existing indices.

We look for the portfolio weights that make the combination of competing indices capture the largest possible fraction of the information contained in the data from the various competing indices. This first component typically captures a large proportion of cross-sectional variations because competing styles tend to be at least somewhat positively correlated. The Edhec Alternative Indices are able to capture a very large fraction of the information. The median percentage of variance explained by the Edhec Alternative Indices is 81.12% across all sub-universes. Edhec Alternative Indices have an appealing built-in element of optimality, since there is no other linear combination of competing indices that implies lower information loss.