Question

Consider the following quote from a Bloomberg article "Hedge funds that invest in stocks returned 7.2 percent annually from 2009 to 2017, which was less than half the S&P 500’s return, according to data from Hedge Fund Research.”1
Explain whether you think the S&P 500 is an appropriate benchmark for hedge funds. If not, how would you design a better benchmark?

Answer 1

What is S&P 500?

The S&P 500 is a market capitalization-weighted stock index comprising 500 large companies listed on the NYSE and NASDAQ. For inclusion, the company must satisfy a range of criteria from size, liquidity, domicile to sector classification and more. However, in terms of composition, it might be less diversified than what most people thought. At the point of writing, the top 50 companies already account for more than 50% of the entire basket.

And in terms of sector concentrations, this is what it looks like.

The top 3 of the 11 sectors make up close to half the index. Information technology dominates at 22%. But you might want to know that giant internet company such as Facebook, Google, and Twitter fell under communication services. So if you consider this, this index has a fairly strong skew towards internet and technology-related stocks.

Hence, when you use the S&P 500 as a benchmark, you are comparing against the performance of a basket of US large-cap stocks that has a strong overweight on tech.

Now, what about hedge funds?

What Are Hedge Funds?

hedge funds are specialized actively managed investments restricted to a niche group i.e. institutions and the rich. In return, they are lightly regulated and given wide latitude to pursue all kinds of strategies across different asset classes globally. Many do not run your traditional long-only strategies and neither are they stock-only funds. So what do these guys do differently?

To see the top-level picture, I pulled some data from Barclayshedge (data as of 1Q 2019). The pie chart below shows you the distribution across USD 3.2 trillion worth of assets managed under different hedge fund strategies.

As you can see, the hedge fund asset and strategy landscape are pretty diverse. There are many ways you can cut it, but this is how Barclayshedge categorizes them. Hedge funds can dabble in any asset class – equities, fixed income, FX, commodities, etc. They can short-sell, take on high leverage, trade derivatives, place concentrated bets, deploy sophisticated arbitrage strategies and more. The limit is your imagination. A good bulk of what hedge funds do are fairly uncorrelated to the markets.

While equity managers may form the largest chunk, the closest match to the S&P 500 is the Equity Long-Only slice which is only 4% of the entire hedge fund assets. And among this 4%, not all are US equities. Even if it is predominantly US, the question of whether or not it is skewed towards large-cap or the tech sector remains. Thus, to take the hedge funds as a group and compare it against the S&P 500 or any other equity index does not make a lot of sense here. It is like comparing the score of your Math exam against another’s English exam, and then determining who is better than the other.

Why Do People Compare Hedge Funds To S&P 500?

S&P 500 is everywhere

It is readily accessible with many liquid investable products based on it such as mutual funds, ETFs and futures. So there is a natural tendency for people to see S&P 500 as a base case. They are not looking at evaluating a hedge fund objectively against what it is supposed to do. Instead, they view it from the angle of opportunity cost. If I park my money into hedge funds instead of S&P 500, am I better off or worse, and by how much?

Return is still king.

History is littered with evidence of people chasing after returns often without understanding or underestimating the risks involved. Greed and fear of losing out are prime motivators. That’s why massive bubbles form and spectacular crashes follow. In the case of S&P 500, it performed phenomenally well after the subprime meltdown in 2008. And we have to thank the central banks worldwide for diligently printing cheap money for this. Now, we are in the midst of the longest bull market in history. Over the past 10 years, S&P 500 rose more than 300% since bottoming in 2009. Hedge funds, on the other hand, put up a mediocre performance, delivering under 80% as a group over the same period. This glaring difference became one of the most talked-about subjects among hedge fund critiques and the media.

But was this always the case? Did hedge funds persistently disappoint in terms of absolute returns?

Return Profile of Hedge Funds Vs S&P 500

Hedge funds did not always underperform. In particular, before 2008, hedge funds were the king. Money was pouring in and new funds sprouted everywhere. The industry grew rapidly from a little over USD 200 billion in 2000 to more than USD 2 trillion in 2008 before the crisis hit.

To get a more complete picture, let’s see how hedge funds and S&P 500 did both during good and crisis periods. Unfortunately, I do not have the monthly performance data from Barclayshedge. So I will be using data from another provider instead – HFRI. It stretches further back to 1990. However, different providers have their own way of slicing and dicing the hedge fund universe. So you will not see the exact same groups as Barclayshedge. But, it is not that important here. All we need is the big picture.

A new asset-weighted benchmark for hedge funds has been introduced – the CSFB/Tremont Hedge Fund Index. The provider, Credit Suisse First Boston Tremont Index LLC, says it hopes the benchmark will help investors see hedge funds as a reliable investment option.

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