Hedge Funds get a lot of criticism from a market that is still predominantly focused on long only strategies. However, one of the severest criticisms levied against them is that they are largely long only strategies, whose use of leverage, means that do not protect investors from downside equity market risk. This is an understandable worry, and indeed, 2008 saw losses across nearly all hedge fund strategies bar something like short-side biased funds. Therefore, it is worth looking more closely at performance. In particular, do hedge funds tend to make directional punts? Moreover, is it worth giving up the discipline to allow them to be discretionary as opposed to a fixed market neutral approach?
Hedge Funds Performance
In order to gauge this here is a regression analysis with the monthly hedge fund results from Dow Jones Credit Suisse Index for Equity Market Neutral and Long/Short Equity Indices. Both indices are US Dollar based and are measured against the S & P 500.
Equity Market Neutral
Source: Dow Jones Credit Suisse
Firstly, it is worth noting that returns are not really correlated as both r-squared numbers are low and, as could be expected, the market neutral index has lower correlation. Secondly, both indices reveal positive alpha generation although this means little given that correlation is low. Both cumulative returns are good, with long/short equity notably outperforming. All of which suggests that the greater discretionary element implied in long/short equity does not result in investors losing money. A point which is especially relevant when it is noted that the S & P 500 lost 5.3% over this period!
Hedge Funds Investment
Hedge funds work over the long term and, investors might well be tempted to allow hedge fund managers the latitude to adopt a discretionary strategy rather than be bound by market neutral. Having said that, the dispersion of results within long/short is far larger than equity market neutral. All of which suggest a strategy of a diversified holdings of long/short equity funds is likely to be optimal. Alternatively, a few core holdings of market neutral funds surrounded by a collection of satellite holdings in long/short equity funds.