It is interesting to watch strategies stay atop the HSBC Hedge Weekly top 20 performance list despite their apparent beta market environment turning negative. Consider the top three hedge funds as prime examples: the Dorset Energy Fund, often correlated to the price of oil; Quantedge Global Fund, in second place and not correlated to traditional systematic CTA strategies; and the Russian Prosperity Fund, whose correlation is stated in the title.

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Hedge Funds

Hedge Funds - An oil fund not entirely correlating to the price of oil

David Knott and Donald Textor’s $159 million Dorset Energy Fund (Class A) is an outstanding example of funds not entirely correlating to their beta. Oil is trading only marginally above its December close, but Dorset is reporting performance up 63.90% year to date. This is a relative divergence in the fund's historic correlation to its beta market environment.

That’s heroic performance, to be sure, particularly given the fund’s worst drawdown still smarting on investor’s minds. From June 2014 until January 2016 the fund, heavily reliant on the performance of energy assets, took a dramatic tumble. Its worst in history drawdown of 70.37% now behind it, Dorset took off in 2016 as energy assets rallied. The near term rolling volatility of the fund isn’t close to the 25.66% annual standard deviation during this period, as volatility in the oil market was generally apparent in the fund's performance.

Hedge Funds - Russian Prosperity fund is generally correlated to its title

The Russian Prosperity Fund (A shares) is, like Dorset Energy Fund, is essentially correlated to a market. As the name implies, Russian Prosperity is the key.

Alexander Branis and his $850 million fund, which was founded in 1996, is up 35.20% year to date as of reporting August 25.

Long-time investors in this fund are troopers. Just years after placing their faith in Branis and his dreams, the 1998 Russian Financial crisis hit. This strong beta market to the downside – which reduced to rubble the unquestioned genius behind of Long Term Capital Management – also has a notch on its headboard in tanking the Russian Prosperity Fund in the process.

Investors lost 90.26% of their allocation at the worst of the drawdown from July 1997 to January 1999. After that terrifying start, the average annualized volatility of 43.22%, enough to scare away even the most adventuresome of investors, might seem like a smooth ride down a lazy river.

Investors have experienced significant pain as well as gain, with a 15.53% average annualized return consisting of a significant amount of upside and downside deviation to smooth out volatility over time. In 2014, for instance, the fund, in the teeth of yet another Russian crisis, this time over the invasion of Crimea, topped the HSBC top 20 in worst performance, down 43.99% that year.

A roller coaster ride indeed, one that has a difficult loss and downside deviation pattern – perhaps too difficult to play the buy on a drawdown game. But also a fund that is reasonably reliable in terms of correlating to its proclaimed market beta.

And then there is Quantedge Global, currently in second place among the high volatility absolute returns winners.

Hedge Funds = Quantedge doesn't seem all that systematic, particularly in its relative value execution

A primary benefit of investing in managed futures CTA strategies is the predictability factor. With a sound understanding of algorithmic market environments, and a degree of candor from the hedge fund, investors can understand when the strategy is expected to succeed and more importantly when it might find difficult beta market environments.

The predominance of managed futures CTA strategies are experiencing a challenging market environment in the wake of the July Brexit vote and the February 11 “V bottom,” when positive CTA performance followed negative stock market events. Likewise, DUNN Capital’s Niels Kaastrup-Larsen called the August market environment “tricky.”

During August only agricultural commodities and volatility provided positive returns attribution for DUNN, according to fund documents reviewed by ValueWalk.

Negative market environments were found most specifically in metals and long term rates, where the central bank picture remains unclear. Energy, which suffered a price reversal and weak force of trend readings in July and August, were the third biggest loser for CTA strategies.

Managed futures CTAs have taken a breather as an investment category in August, with the largest CTAs in the Societe Generale CTA Index down collectively -3.10% in August, but nonetheless up 2.19% year to date.

"CTA strategies were one of the better performing strategies for investors in the first half of the year, and have enjoyed considerable inflows compared to other hedge fund strategies,” Tom Wrobel, Director of Alternative Investments Consulting at Societe Generale, said in a statement. “Markets have recently become slightly more challenging, with CTAs giving back some of the gains made earlier in the year. Whilst August performance has dipped, year to date figures for our broad-based CTA and Short-Term Traders indices are still looking good."

Short-term time horizon traders, a sub category in certain beta market environment analysis, were down -3.41% on the month. The short term traders are reasonably similar in performance to the slightly more diverse SG CTA Index. The SG Short-Term Traders index is up 2.57% on the year, nearly 0.38% better. The SG CTA Mutual Fund Index, where CTAs are required to engage in a SWAP transaction to hold derivatives in a portfolio, adding to the cost of the product, is down -3.08% on the year and lost -2.65% in August.   

By contrast, DUNN's Agriculture Program, a sometimes feature on the HSBC Hedge Weekly top 20 list, now with $655 million under management, is nonetheless up 7.94% year to date after shedding -3.54% in August.  In 2014 DUNN’s WMA fund finished ninth on HSBC’s much watched performance listing, generating 35.08% net returns. That year the fund finished behind the press magnet Pershing Square Intl and the sometimes beta market defying performance of the Tulip Trend Fund, LTD. Despite a negative market environment, the Tulip is currently seventh on the HSBC absolute returns list despite the challenging market environments.

Systematic CTA performance can be generally modeled through various algorithmic market environments. It has a deserved reputation as being noncorrelated, but it is important to recognize it does not perform positively in all situations.

Managed futures playing the “hero role” during a high percentage of periods when long-only equity funds were withering under the heat of volatility is nothing new. It has come to be expected among sophisticated hedge fund allocators. But there is nuance to this story. There are periods when the strategy might not perform positively when the stock market crashes. The key to allocating to a strategy is understanding its weaknesses first.

The Brexit “V bottom” was a correlation oddity, as several deep market signals were askew. It was because of a lack of correlation, a correlation breakdown, that led to strategy outperformance during the turbulent period.

There has been much insider consternation regarding Quantedge’s edge. While the fund has not responded to questions from ValueWalk, its margin to equity ratios and even its "quantitative,” systematic bonafides have come into question. In what some analysts consider a strategy mixture that includes relative value with a degree discretion, the fund is defying beta market environment analysis, which makes modeling performance through various market environments difficult. Some institutional investors consider this a negative. Quantedge, for its part, clearly advertises volatility to a mostly individual high-net worth investor base -- and it delivers as promised without much detailing how it works.