It’s important to understand the historic returns of various hedge fund strategies to determine which best suits an investor’s particular risk/return profile. Before evaluating strategies, a basic understanding of risk profiles as measured by fundamental analysis should be considered. These ratios are Alpha, Beta, standard deviation, R-squared, and the Sharpe Ratio.
- Alpha is a measure of performance of an asset on a risk-adjusted basis compared to a benchmark return. An Alpha of 2.0 means that the fund outperformed its benchmark by 2%.
- Beta is a measure of systematic risk compared to the market as a whole. A beta lower than 1 means that the security is less volatile than the market; 1 means its equal to the market; and a beta over 1 means that the security is more volatile than the market.
- The Sharpe Ratio is the average return earned in excess of the risk-free rate when taking into account volatility. Generally the greater the Sharpe Ratio, the more attractive the risk-return profile.
- The standard deviation of returns is a measure of how dispersed historic returns are as a measure of distance from the mean return. Simplified, the greater the standard deviation of a security or basket of securities, the greater the expected volatility.
- R-squared is the percentage of movement that can be explained by movements from a benchmark index. A fund with low R-squared deviates from the index, whereas an R-square of 100 means that all movement of a particular security is completely explained by movements of the index.
These measurements, not just historic returns, are important to understand and gauge how an investment is likely to behave in different market environments.
Another important consideration is how correlated these specific strategies are to specific market dynamics. There are countless variables and variations to hedge fund strategies. Strategies could be linked to U.S. market trends relating to certain sectors such as energy, technology, or healthcare. There are funds focused on asset specific movements in commodities, currency, credit, and special and distressed situations. Funds also can be geographically focused and bullish on China, India, or emerging markets. Mind you, all of these strategies can be formed around a short-bias, where bets against sectors are a main driver. Additionally, quant-based strategies are driven by computerized algorithmic trading and can employ a specific top-line strategy, or be based primarily on momentum trends powered by computerized models.
As explained in a previous blog, hedge funds can be classified based on strategy. These are generally broken down by equity hedge strategies, event-driven, macro, and relative value. Broadly, these categories can also be classified according to regional investment focus like a certain country (Brazil) or block of countries (The Eurozone). Funds of funds can encompass all of these strategies for diversification effects, and can be classified according to risk profile. For example, a fund of funds classification can be labeled conservative or market defensive.
Emerging markets: TTM: 4.98%, 3 year: 5.72%. The best performing subset of emerging markets funds was activist the China index at 28.03% returns over twelve months ending June 2015. The worst performing subset of emerging markets strategies was the Russia/Eastern Europe index at -18.33%.
Macro strategies: TTM: 4.11%, 3 year: 1.82%. The best performing subset of macro driven funds was diversified systematic at 8.68% returns over twelve months ending June 2015. The worst performing subset of macro strategies was the discretionary thematic index at -.01%.
Fund of funds: TTM: 3.86%, 3 year: 6.24%. The best performing subset of fund of funds was market defensive strategies at 4.82% returns over twelve months ending June 2015. The worst performing subset of fund of funds strategies was the conservative index at 2.71%.
Equity Hedge: TTM: 2.59%, 3 year: 8.44%. The best performing subset of equity hedge was the technology/healthcare index at 14.33% returns over twelve months ending June 2015. The worst performing subset of equity hedge strategies was the energy/basic materials index at -14.86% over twelve months. This isn’t surprising given the recent shift in supply and demand factors related to oil.
Relative Value: TTM: 1.49%, 3 year: 6.51%. The best performing subset of relative value funds was volatility fixed-income asset backed funds at 5.28% returns over twelve months ending June 2015. The worst performing subset of relative value strategies was the yield alternatives index at -3.05%.
Event Driven: TTM: -.14%, 3 year: 7.67%. The best performing subset of event driven funds was activist strategies at 9.29% returns over twelve months ending June 2015. The worst performing subset of event driven strategies was the distressed/restructuring index at -5.89%.
Overall, the best performing sectors were Equity long/short focused on technology and healthcare over the last 12 months. The worst performing funds were focused on Latin America and Eastern Europe.
On an equal-weighted index of over 2,000 single manager funds reported by HFR, hedge funds returned an almost 7% annualized return over three years. Over 25 years, hedge funds returned over 10% on an annualized basis, higher than the S&P500. Hedge funds also displayed a lower standard deviation as a measure of lower volatility. Additionally, hedge funds had a higher Sharpe Ratio, which means hedge funds had a better risk return profile than the market. There is sufficient evidence that validates the attractiveness of investments in hedge funds as an amplifier of returns and an instrument to protect capital through volatile markets.
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