When Hindsight Turns into Foresight: Replicating Funding Efficiency


We now have analyzed dozens of private and non-private market funding methods, resembling merger arbitrage and personal fairness, respectively, over the previous couple of years, and one frequent theme has emerged. A lot of the merchandise described in additional than 300 analysis papers merely present publicity to the inventory market in difficult wrappers. As soon as the tide goes out, the danger publicity is similar in all places.

We are able to show this phenomenon in several methods. The commonest method is to easily run an element publicity evaluation. Funding merchandise marketed as providing uncorrelated returns typically exhibit excessive betas to the inventory market, which highlights an absence of diversification advantages.

However there’s a good less complicated and maybe extra highly effective strategy to illustrate this level: through the use of a mix of the S&P 500 and money to copy the historic efficiency of an funding product with the identical degree of danger.

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We just lately created Time Machine, a freely accessible software with which buyers can replicate the efficiency of any mutual fund, exchange-traded fund (ETF), or US inventory utilizing simply the S&P 500 and money.

To show Time Machine’s facility on social media, we analyzed the iMGP DBi Hedge Technique ETF (DBEH), which tracks the 40 main lengthybrief fairness hedge funds, and located that an 81% allocation to the S&P 500 and a 19% allocation to money would have delivered virtually the identical efficiency with the identical volatility.

Replicating a Lengthy–Brief Hedge Fund ETF with the S&P 500 and Money

Chart showing the effects of Replicating a Long-Short Hedge Fund ETF with S&P 500 and Cash

Supply: Finominal

From our perspective, these Time Machine outcomes referred to as the utility of this ETF into query. A revered Twitter commentator, alternatively, countered that the fund’s three-year observe file was too brief to attract any conclusions and that our replication course of was merely based mostly on hindsight. These have been truthful factors, so we expanded our evaluation.

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Lengthy–Brief Fairness Hedge Fund Efficiency

For the reason that purpose is to copy equity-like returns with much less danger, or precisely what a S&P 500 plus money portfolio supplies, we use lengthy–brief fairness hedge funds as case research. To judge every, we chosen indexes which have prolonged histories throughout a number of market cycles. The Eurekahedge Lengthy Brief Equities Hedge Fund Index and HFRX Fairness Hedge Index each have 20 years of historical past, which needs to be adequate.

However Eurekahedge has a CAGR of 8.1% versus 2.0% for HFRX. Provided that each combination the returns of single lengthy–brief fairness hedge funds, such a big discrepancy is alarming and makes it troublesome to guage every technique’s attractiveness. Which one is best?

After all, the variety of funds in every index varies, however the essential driver could also be that Eurekahedge permits new fund managers to import their previous observe data as soon as they begin reporting. Since solely fund managers with good previous efficiency ask to be included in these indexes, a type of survivorship bias could also be at work. So, capital allocators can be clever to disregard the Eurekahedge index and focus, as we do in the remainder of our evaluation, on the extra life like HFRX.

Lengthy-Time period Efficiency of Lengthy–Brief Fairness Hedge Funds

Chart showing Long-Term Performance of Long-Short Equity Hedge Funds

Supply: Finominal

Replicating Lengthy–Brief Hedge Funds

The HFRX Fairness Hedge Index’s volatility was 6.1% over the 2003 to 2023 interval, which we may have replicated with a 52% allocation to the S&P 500 and 49% to money. However the replication portfolio’s CAGR would have been 3.7% in contrast with 2.0% for the hedge funds, and the drawdown would have fallen from 31% to 19%. This leads to considerably greater risk-adjusted returns for the replication portfolio.

To make sure, buyers should not have to conduct any due diligence on the S&P 500, whereas hedge fund evaluation is an costly course of that requires an preliminary evaluation in addition to ongoing monitoring. Moreover, an S&P 500 ETF right now has mainly zero bills, whereas hedge funds include excessive administration and efficiency charges. So, who wouldn’t favor the replication portfolio?

Replicating HFRX Fairness Hedge Index with S&P 500 and Money

Supply: Finominal

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Additional Ideas

Though a easy S&P 500 and money portfolio would have achieved greater absolute and risk-adjusted returns than lengthy–brief fairness hedge funds, may our evaluation nonetheless be based mostly on hindsight and have little relevance for anticipated returns?

Sure, however given the 0.71 correlation between the HFRX Fairness Hedge Index and the S&P 500, there’s little query that lengthy–brief fairness hedge funds provide diluted fairness publicity.

Moreover, the HFRX index’s upside beta to the S&P 500 was 0.16 in contrast with 0.25 on the draw back. As such, fairness hedge funds observe falling shares greater than rising ones. Clearly, this ratio is at parity for any S&P 500 and money mixture.

Sooner or later, hindsight turns into foresight.

For extra insights from Nicolas Rabener and the Finominal workforce, join their research reports.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Picture credit score: ©Getty Photos / Ryan Djakovic

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