prologue
Over the past several years, we’ve analyzed dozens of investment strategies in each of the public and private markets, including merger arbitrage and private equity, and one common theme has emerged. Most of the products described in over 300 research papers simply offer exposure to the stock market with complex wrappers. When the tide goes out, your exposure to risk is the same everywhere.
This phenomenon can be demonstrated in various ways. The most common approach is simply to perform factor exposure analysis. Investments advertised as providing uncorrelated returns often exhibit high betas to the stock market, highlighting their lack of diversification benefits.
But there is an even simpler and perhaps more powerful way of explaining this point. Replicating the historical performance of investments with the same level of risk using a combination of the S&P 500 and cash.
we recently created Time Machineis a freely accessible tool that allows investors to replicate the performance of mutual funds, exchange-traded funds (ETFs), or US stocks using only the S&P 500 and cash.
To demonstrate Time Machine’s capabilities on social media, we analyzed the iMGP DBi Hedging Strategy ETF (DBEH), which tracks 40 leading long stocks.–After shorting an equity hedge fund, we found that allocating 81% to the S&P 500 and 19% to cash yielded roughly the same performance at the same volatility.
Replicating a Long/Short Hedge Fund ETF using the S&P 500 and cash
Source: Finominal
From our perspective, these Time Machine results cast doubt on the usefulness of this ETF. Meanwhile, a respected Twitter commentator countered that the fund’s three-year track record was too short to draw any conclusions, and that our replication process was simply based on hindsight. These were valid suggestions, so we expanded our analysis.
Equity long-short hedge fund performance
Since the goal is to replicate equities-like returns with less risk: what the S&P 500 Plus cash portfolio offers, we use an equities long-short hedge fund as a case study. To evaluate each, we have selected indices that extend their history across multiple market cycles. Both the Eurekahedge Long Short Equity Hedge Fund Index and the HFRX Equity Hedge Index have 20 years of history, which should be plenty.
However, Eurekahedge has a CAGR of 8.1% compared to 2.0% for HFRX. Given that both are sums of long and short hedge fund returns for single stocks, such a large difference is alarming and makes it difficult to assess the attractiveness of each strategy. Which would you like to choose?
Of course, the number of funds included in each index will vary, but the deciding factor may be that Eurekahedge allows new fund managers to import historical performance when they start reporting. There may be a form of survivorship bias at work, as only fund managers with good historical performance will want to be included in these indices. Therefore, capital allocators would be wise to ignore the Eureka Hedged Index and, like the rest of the analysis, focus on his more realistic HFRX.
Long-term performance of equity long-short hedge funds
Source: Finominal
Replicating Long/Short Hedge Funds
The HFRX Equity Hedged Index volatility was 6.1% over the period 2003-2023. This could have been replicated by assigning 52% to the S&P 500 and 49% to cash. However, his CAGR for replicating portfolios should have been 3.7% versus 2.0% for hedge funds, with drawdowns dropping from 31% to 19%. This significantly improves the risk-adjusted return of the replication portfolio.
Sure, investors don’t need to do due diligence on the S&P 500, but hedge fund analysis is an expensive process that requires initial evaluation and ongoing monitoring. Moreover, his S&P 500 ETF today has essentially no expenses, whereas hedge funds charge high management fees and performance fees. So who wouldn’t love a replication portfolio?
HFRX Equity Hedged Index Replicated in S&P 500 and Cash
Source: Finominal
Further consideration
A simple S&P 500 and cash portfolio would have achieved higher absolute and risk-adjusted returns than an equity long-short hedge fund, but wouldn’t our analysis still be based on hindsight and have little relevance to expected returns?
Yes, but given the 0.71 correlation between the HFRX Equity Hedged Index and the S&P 500, there is little doubt that equity long-short hedge funds offer diluted equity exposure.
Additionally, the HFRX index had an upper beta of 0.16 and a lower beta of 0.25 against the S&P 500. That’s why equity hedge funds chase falling stocks more than rising stocks. Clearly, this ratio is comparable for any S&P 500 and cash combination.
At some point, hindsight turns into foresight.
Nicolas Rabener and Finominal team, please sign up research report.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Ryan Djakovic
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