The  great hedge fund reversal? It’s been a wild year in the markets as hedge funds have struggled for returns, with the early part of this year being a horrendous one for many funds with widespread financial carnage punishing even the best of the best. Apparently things have been so strange this year, that hedge funds saw their fortunes change, with the worst becoming the best through the first part of this year, according to analysts at Morgan Stanley Prime Brokerage team.

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The great hedge fund reversal

In their September 27 “Hedge Fund Thought Piece,” John Schlegel and team highlighted their analysis of cumulative hedge fund returns from January 2015 through August 2016. They found that the average fund in the bottom quartile between January 2015 and February 2016 was down 10.6%. However, the funds in that bottom quartile during that time frame were up by an average of 9.3% between March and August 2016. In fact, they actually beat all of the other quartiles.

 Hedge Fund Reversal
Hedge Fund Reversal

Why such dramatic performance shifts?

The Morgan Stanley team believes that reversals running both across and within hedge fund strategies drove this dramatic shift in performance.

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Schlegel and team compared the reversals that have taken place over the last 18 months to those observed from 2008 to 2009 and 2011 to 2012.

Factor biases become a tailwind for hedge fund longs

They explained that among Equity Long/ Short funds, each fund’s net exposure levels drove at least some of the shift. However, they also found that reversals in some factors contributed to the change in performance among these funds as well. They observed that market beta explains some of the reversal among this cohort of funds because higher net funds took a greater hit from the drawdown and have recorded bigger rebounds since the middle of February.

They attribute the reversals among other equity fund categories to factor biases, however. Schlegel and team observed that over the last couple of years, factor biases have shifted from being a major headwind between March 2014 and February 2016 to being a “modest” tailwind now, particularly for any long positions held by hedge funds right now.

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The analysts add that short positions had also benefitted from factor biases before February, but that tailwind sharply reversed after that point. They peg the factor contribution to total alpha in the U.S. as still being in the negative year to date. This is also the second time it has been negative within the last three years. However, it’s improving, having shifted from -2.8% at the end of the first quarter to -1.7% year to date at the end of August.

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Alpha excluding style factors is now in the green, although it’s still not as good as it was between 2012 and 2015.

 Hedge Fund Reversal
Hedge Fund Reversal

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