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Deutsche Bank quants explain hedge fund underperformance
The market environment for hedge funds in 2015 has been “marked by an acute and prolonged de-risking episode,” a recent quant piece from Deutsche Bank notes. In fact the bank’s “volatility factor,” a measure that approximates high risk and low risk equity performance, reveals the most recent 2015 episode of de-risking was “deeper than that during (second half of) 2014, and its impact on fundamental equity managers was severe,” with its model hedge fund portfolio underperforming the general market by -4.8 percent since June.
Hedge fund underperformance is not a new issue, a commonality in the recent quantitative easing period
Separate analysis highlights a negative gross average monthly negative performance of -0.96 for the Barclay Hedge Fund Index. During this same period, June to October, the S&P 500 delivered an average negative monthly performance of -0.146. This leads to an average monthly divergence between stocks and a hedge fund index of -0.814.
The level of underperformance highlighted by Deutsche Bank might not be as significant as one thinks. Using the period of quantitative easing as a benchmark, this is visible when comparing the performance of the S&P 500 Total Return Index to that of the Barclay Hedge Fund Index where investors can witness what is a very different level of performance. In 2014 the S&P was up 13.69 percent versus the hedge fund index, up only 2.88 percent. The return differential resulted in an annual -10.81 percent underperformance by hedge funds, which is actually close to the annualized underperformance by hedge funds in the June to October period cited in the Deutsche Bank study. In other words, the recent underperformance by hedge funds, which are typically correlated to stocks nearly ¾ of the time, exhibited a significant lack of correlation on a price appreciation basis in 2014. The same thing happened in 2013, when the S&P 500 Total Return Index was up 32.39 percent yet hedge funds were up only 11.12 percent, for a massive underperformance of -21.27 percent.
In other words, at least when measured during the last several years of what has been called market numbing quantitative easing, the vast average of hedge funds have been significantly underperforming a simple investment in a the S&P 500 index. While the Deutsche Bank report only focused on the June through October period, what they were really touching on is a much wider performance gap issue. The question is, with most hedge funds long only – and long only hedge funds being among the worst performers on the HSBC Hedge Weekly performance ranking – why were hedge funds underperforming by so much?
Deutsche Bank says hedge fund underperformance triggered by volatility factor, which is different than VIX volatility
The significant recent underperformance by stocks since June was triggered, in large part, by exposure to volatility. Just over half the June to October underperformance of Deutsche Bank’s model hedge fund portfolio to stocks, 2.6 percent over five months, is attributable to Deutsche Bank’s volatility factor exposure, the report said.
It was almost a year ago that the Deutsche Bank Quantitative Strategy Research department, headed by Allen Wang, created the volatility factor formula, a ratio of “long high risk stocks / short low risk stocks.” In regards to the thesis for hedge fund underperformance, the validity of the measure is, in part, dependent on its record as an indicator of how actual stock market volatility impacts hedge fund performance. This would require testing of the Deutsche Bank volatility measure relative to hedge fund performance and actual CBOE VIX measured volatility.
From Deutsche Bank’s perspective it is this volatility factor that “has been a major driver of systematic factor returns during 2015.”
…Standard quantitative factors (styles) have, on average, tilted towards low volatility throughout the year; contributing to a large portion of their returns. Notably, momentum has a strong low volatility exposure which has contributed to roughly one-fifth of its return to end of October. The return contribution to other styles is even higher topping out for Quality (ROE) for which exposure to the volatility contributed to roughly two thirds of its performance.
While some hedge fund allocators might challenge the idea that a hedge fund performance should both so negatively underperform the general stock market, but even more interesting is the negative performance attribution given to volatility, a market feature that some hedge funds relish in seeing.
The Deutsche Bank “volatility factor” is a ratio of high risk to low risk stocks with a correlation factor
The volatility factor “reflects sentiment in the broad market,” but is different, to be sure, as it measures a relative value distinction between what are categorized as “high risk” and “low risk” stocks. During periods of crisis, most equities correlate closer to one and thus the “high risk” and “low risk” stock might experience a different correlation profile during such periods of actual overall market volatility. Looking at the Deutsche Bank drawdown relative to volatility factor chart makes that point of tight correlation, which appears to have led markets at times.
This story first appeared in ValueWalk.