Wednesday, February 22, 2012

Is bad timing the reason for hedge funds' underperformance?

The universe of hedge funds tracked by the Dow Jones/CS Hedge Fund Index has underperformed the SP500 by some 15% since the start of 2011. On a risk-adjusted basis the underperformance isn't as bad when one considers that a diversified pool of hedge funds is much less volatile than the equity index (as evidenced from the chart below). Nevertheless, this is a black eye for the hedge fund industry.

Is there a simple explanation for such a terrible performance relative to the overall markets? The folks at JPMorgan argue that it has to do with markets' correlations. Most hedge fund type strategies (macro excluded) according to them underperform during periods of high correlation.

Source: JPMorgan

This is not a very satisfying explanation because the underperformance continued even after correlations across and within asset classes came down this year. A more likely explanation is that hedge funds became extremely defensive, particularly in the late fall of last year. Many hedged their portfolios, increased cash positions (reduced balance sheet), or put on large short positions. They ended up participating in the market correction from late summer, possibly through October. But because they re-positioned their portfolios to be much more defensive (potentially at the worst time), they did not fully participate in the market rally that followed. This lag to the upside is quite visible in the first chart (above). Much of hedge funds' underperformance may therefore be simply a case of really bad timing.
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