All hedge funds are not created equal so pick carefully

The new study "Hedge Funds: A Dynamic Industry in Transitions" is a treasure trove of information on hedge fund behavior of the last two decades. Written by Peter Lee, Andy Lo, and Mila Getmansky   Sherman, it by far the most informative analysis of hedge funds to date. I will highlight some of their tables and figures with a focus on my special interest of global macro and managed futures.

A look at the correlation matrix of across hedge fund styles shows that an investor who wants diversification should focus on managed futures and global macro. While short bias has a strong negative correlation, its correlation is based on a tilt away from long equity holding. It will generally do well only in down market scenarios. Managed futures and global macro, given the wide set of asset classes traded, will have the greatest natural diversification in either up or down markets. The key to these two styles is that they are different. 

Each hedge fund style has different conditional exposures to market factors. These differences to linear factors are what creates the correlation differences. Managed futures and global macro provide exposure to commodities and currencies relative to other hedge fund styles. Global macro has an equity factor focus that is not found in managed futures.  Most hedge fund styles have significant equity exposures.

There is a cost associated with this diversification. Managed futures and global macro volatility will be higher and the amount explained by the seven factors tested will be lower. Both styles have a higher level of uniqueness as measured by their low r-squared values.

Using a four factor model, an investor will get different factor sensitivities. For managed futures, there is no equity sensitivity, only sensitivity to the bond market. Global macro has a slight tilt to equity exposure but no sensitivity to the size spread factor.

One of the problems with using these linear factor models is that the ability of a seven or four factor model to explain out sample behavior is poor especially for managed futures and global macro. There is a strong out of sample link between linear factors and long/short equity for the simple reason is that these hedge fund managers have a more narrow focus. 

The performance across years is highly variable with the best style of three ago is not the best today. The top performing hedge fund style will change from year-to-year. Managed futures will do well when other hedge fund styles under-perform. The same applies to global macro; however, the 2011-2013 was not kind to strategies that had broad exposures.

The overall performance statistics tell an interesting tale. Beyond volatility, managed futures and global macro have better skew and kurtosis characteristics and the maximum drawdowns are actually lower over the entire period.

Performance has changed in the post-crisis period with the ascent of multi-strategy and fixed income arbitrage as having good risk-adjusted returns. Global macro provides good risk-adjusted returns while managed futures have shown a larger relative drawndown. Clearly, performance ha been dynamic and does not follow long-term patterns.

The highlights we have shown is just a sample of the data and facts available from this study. It shows that manage exposures and carefully picking the right managers and strategies is essential for successful hedge fund investing.