What can we learn from recent hedge fund performance?
Useful lessons for retail investors
Every couple of years, when markets overall perform well, one starts to hear about the death of hedge funds. Investors who ‘no longer see the value’ either pull money out in droves or at least negotiate better terms, and the popular press decrees the end of an era. However, if you look under the hood right now, you’ll see that some funds are thriving. What sets them apart, and what can we learn from their performance?
The hedge fund industry is notoriously secretive and opaque, which can make it quite difficult to understand the goings-on within it, especially for retail investors with little to no access to anything but public disclosures and some surface news articles. Still, we think there are a few key themes worth calling out:
- Macro hedge funds are dramatically outperforming traditional equity funds
- The best and largest funds are the strongest
Below we will discuss each of these topics and, importantly, what it means for the average investor.
Macro hedge funds outperform
There are a number of ways to categorize funds, but most simple taxonomies create buckets based on the overall strategy and/or the asset class that the fund focuses on. The most prevalent type of fund is called “Equity Long/Short,” which is where the fund primarily invests in stocks and can either buy them (the long portion) or sell them (the short portion) as they see fit.
How have these funds done lately? Not very well. In fact, the average equity fund is down ~15% through the first half of the year. Adjusting for their net positioning, these funds are only as good or worse than their benchmark. This leaves the average fund in this category with zero alpha, which is troubling as generating lowly-correlated and positive excess return is the foundation of their business and the goal of their investors’ allocations.
On the other hand, so-called macro funds are thriving. Through the first half of the year, they were up 9% in aggregate. Some marquee firms have gained significantly more (for instance, Bridgewater Associates is reportedly up +35% in their Pure Alpha fund).
Though there are perhaps secular explanations for how good any particular investment strategy is over long periods of time (for instance, how efficient that part of the market is, how crowded the strategy is, etc.), we believe that this performance reflects a simple truth – macroeconomics is driving the market right now, and those who understand macroeconomics can benefit while others suffer. It isn’t that some fund managers got better, but rather that market conditions allowed their strategies to succeed. One illuminating heuristic we can look at is the degree of co-movement in the equity market. Measured over the last year, correlations between stocks have been high, making it extremely hard to find winners and losers via stock-picking.
Early on in the pandemic, macro was also king, but as the economy transitioned to its new normal, there was certainly ample opportunity to pick stocks – for example, think of the work-from-home winners or the companies that reopened ahead of others. This year, however, the drivers have mostly been inflation and its knock-on implications for interest rates as well as the burgeoning recession in the US, with even more global complexity based on the war in Europe, commodity shortages, plummeting currencies, and debt problems in China.
What should a retail investor take away here? We believe that all investors should consider macro no matter the economic regime and especially important right now if you want to be a good steward of your money. With no end in sight to the number of macroeconomic woes we face, better to get a handle on your risks and exposures as soon as possible.
Strong funds have maintained their foothold.
Another interesting facet of recent hedge fund performance is that the performance gap between good and bad funds has increased. While many ill-performing funds are seeing outflows, some blue chips are even considering raising fees. Even with the complexities of the current environment, large funds are reporting historically high levels of confidence.
The best funds and the largest funds are not necessarily the same, though they are often related as good performance over time brings new assets (the caveat being that some strategies can handle much more AUM than others). Let’s unpack some characteristics that underlie both the best and largest funds.
For one, the funds that have been doing well likely have the flexibility to shift money across strategies to the one that best fits the tide. In particular, the larger the fund, the more likely it is to have several different strategies that can do well in times of market turbulence and macro upheaval.
As well, while the small size is often an advantage when there are small opportunities that require trading often in expensive-to-buy securities, in today’s climate, some of the best trades are longer-term, directional, and exist in deep markets.
Lastly, larger firms, in particular, have more resources, which are essential when the quality of a trade depends on combining a lot of data points (as opposed to a more standard analysis based only on company financials, some earnings calls, and maybe a few conversations with experts).
So then, what should a retail investor take away here? We suggest pulling in data and analytical tools to keep you apprised of how macroeconomic market trends affect your portfolio. The current regime provides challenges even for professional investors, and a lot of data and analysis is necessary in order to wrangle the key drivers of today’s markets. Strategies that have performed well in the past might not be the optimal ones right now (for this reason, we favor building a solid, diversified base portfolio with a macro tilt, which is usually a good way to stay ahead of the current regime). Opportunities can be highlighted by systems that constantly evaluate a broader range of securities than a single human could on their own and by using platforms that get the scale from serving many users rather than doing everything yourself.
Given the time and data self-directed investors, like ourselves, would need to monitor and evaluate the ever changing macro environment, we built Global Predictions as an all-in-one platform to help manage your portfolio.