November 2016, what many thought was unthinkable became a reality when Donald Trump assumed power in the United States. His unpredictability and outspokenness had already spooked markets in the lead up to the election, but what has happened since has been quite remarkable in its own right. Markets, which once feared the idea of a Trump presidency embraced it whole-heartedly, and what President Trump had once called ‘a big, fat, ugly bubble’ got a new lease of life. The rhetoric was toned down and the handshakes were tempered as the prospect of a renewed fiscal stimulus coupled with economic de-regulation set about trying to woo markets. While little has materialized save a deadlock on Capitol Hill, markets have risen to new highs.
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The piece below will look at the performance of US long short equities focused hedge funds which along with the rest of the hedge fund industry have received a boost from the strong momentum in underlying markets. In addition, we explore the returns for specific sector focused strategies – financials, healthcare and IT and evaluate the systematic drivers of performance for North American long short equity hedge fund managers over the years. The piece concludes with a look at investor allocations across North American mandates which have seen a sharp trend reversal this year as investor appetite for hedge funds continues to improve.
Figure 1 depicts the performance of the Eurekahedge North America Hedge Fund Index versus comparable benchmarks since 2007. Over the period depicted, the Eurekahedge North America Hedge Fund Index has posted annualized returns of 6.10%, ahead of the MSCI USA IMI Index and its subgroup the MSCI USA Value IMI Index which gained 5.90% and 3.86% respectively while lagging the MSCI USA Growth IMI Index which delivered annualized returns of 7.08%. The results should hardly come as a surprise – North America focused equity long short hedge funds saw relatively contained drawdowns in 2008 which has helped them outperform the MSCI US IMI Index over the almost 10 year period depicted (see Table 1). Further, across investment styles, growth has done considerably better when compared to value strategies which have as of late fallen out of fashion given the markets growing love for expensive price-to-earnings multiples.
Figure 1a: Eurekahedge North America Long Short Equity Hedge Fund Index since 2008
Figure 1b summarizes the Trump Presidential effect. It starts with a market scare in October last year when polls showed that Hilary Clintons lead was narrowing but then reverses quickly as a Trump presidency materialized in November. Over the 12-month period ending August, North American long short equity hedge funds are up 7.80% while the MSCI US IMI Index has gained 13.74% on the back of the market rally that has ensued since (barring the interruption from the Korean crisis in August 2017).
Figure 1b: Eurekahedge North America Long Short Equity Hedge Fund Index - last 12 months
Table 1 summarises the key performance statistics for the Eurekahedge Hedge North America Long Shorty Equity Index relative to comparable benchmarks. Key takeaways include:
- The biggest outperformance on record for North American long short equities hedge fund managers came in 2008, when they outperformed the underlying benchmarks by over 20%. Since then, managers have generally underperformed the MSCI US Index though have fared much better in relation the MSCI US Value Index.
- Sharpe ratios (risk-adjusted returns) for North American long short hedge fund managers exceeded those for the underlying market benchmark over the 5 year period, coming in at 1.29 versus 1.12 the MSCI US Index and 1.15 for the SP500 Index. In recent years risk-adjusted returns have lagged market benchmarks owing in part to the strong market rally.
- Across all 5, 3 and 2 year time horizon, North American long short equity funds have posted lower annualized volatilities, almost half the levels seen for comparable market benchmarks.
Table 1: Eurekahedge ESG Fund Index vs. comparable benchmarks
|Eurekahedge North America Long Short Equities Hedge Fund Index||MSCI USA IMI Index||S&P 500 Index||MSCI USA Growth IMI Index||MSCI USA Value IMI Index|
|August 2017 year-to-date||3.29%||9.92%||10.40%||16.02%||3.64%|
|5 year annualised returns||7.68%||11.96%||11.93%||12.67%||10.24%|
|5 year annualised volatility||5.18%||9.77%||9.53%||10.37%||9.69%|
|5 year Sharpe Ratio (RFR = 1%)||1.29||1.12||1.15||1.13||0.95|
|3 year annualised returns||3.61%||6.94%||7.25%||8.46%||4.42%|
|3 year annualised volatility||5.31%||10.32%||10.10%||11.01%||10.09%|
|3 year Sharpe Ratio (RFR = 1%)||0.49||0.58||0.62||0.68||0.34|
|2 year annualised returns||5.72%||11.47%||11.95%||11.96%||10.43%|
|2 year annualised volatility||5.47%||10.16%||9.75%||10.88%||9.89%|
|2 year Sharpe Ratio (RFR = 1%)||0.86||1.03||1.12||1.01||0.95|
Figures 2a-2c look at the aggregate performance numbers for long short equity hedge fund managers that operate with a sector specific bias. For the purposes of this piece, we will look at three key sub-sectors that have contributed strongly to underlying market performance – financials, healthcare and IT.
US equity long short hedge funds investing with a bias towards the technology sector posted the best returns, up 11.93% as of 2017 August year-to-date. Health care focused hedge funds were another beneficiary of the Trump rally, raking in gains of 9.30% as market bought into healthcare/pharma stocks following the defeat of Hillary Clinton who was expected to ramp up regulations on this sector. Hedge funds focused on US financials have also posted solid gains, up 4.53% (outperformance relative to the average North American long short equity hedge fund) for the year as Trump’s de-regulation mantra pervaded into the financial sector as well.
Figures 2a-2c: Performance of sector focused US long short equities hedge funds
Table 2: Performance of sector focused US long short equities hedge funds
|US Financials Focused Long Short Equity Hedge Funds||US Healthcare Focused Long Short Equity Hedge Funds||US Technology Focused Long Short Equity Hedge Funds||SP 500 Financials||SP 500 HealthCare||SP 500 Information Technology|
|August 2017 year-to-date||4.53%||9.30%||11.93%||5.67%||17.74%||25.27%|
|5 year annualised returns||13.50%||9.70%||7.95%||14.96%||15.92%||15.67%|
|5 year annualised volatility||7.44%||8.18%||4.66%||13.46%||11.75%||12.68%|
|5 year Sharpe Ratio (RFR = 1%)||1.68||1.06||1.49||1.04||1.27||1.16|
|3 year annualised returns||13.16%||5.11%||7.33%||9.16%||8.35%||15.03%|
|3 year annualised volatility||8.78%||8.70%||3.61%||15.21%||12.56%||14.47%|
|3 year Sharpe Ratio (RFR = 1%)||1.38||0.47||1.75||0.54||0.59||0.97|
|2 year annualised returns||13.98%||1.12%||6.69%||13.82%||7.40%||22.85%|
|2 year annualised volatility||9.91%||9.53%||3.55%||16.29%||12.86%||14.41%|
|2 year Sharpe Ratio (RFR = 1%)||1.31||0.01||1.60||0.79||0.50||1.52|
Table 3 depicts the correlation matrix for North America long short equity hedge funds across growth and value styles broken down across different market cap sizes. The key takeaway from this table is the relatively lower correlation across the board to value style investments, while a relatively higher correlation to growth style of investing. Second, in general, the correlations are relatively smaller when viewed across large caps, which makes intuitive sense. No investor in their right mind would reward a fund manager with lavish performance fees for investing in well-known and well researched large cap names. More on this later.
Table 3: Correlation matrix (for returns since January 2007)
|Eurekahedge North America Long Short Equities Hedge Fund Index||MSCI USA Growth Large Cap Index||MSCI USA Growth Mid Cap Index||MSCI USA Growth Small Cap Index||MSCI USA Value Large Cap Index||MSCI USA Value Mid Cap Index||MSCI USA Value Small Cap Index|
|Eurekahedge North America Long Short Equities Hedge Fund Index||1.00|
|MSCI USA Growth Large Cap Index||0.91||1.00|
|MSCI USA Growth Mid Cap Index||0.93||0.95||1.00|
|MSCI USA Growth Small Cap Index||0.94||0.92||0.97||1.00|
|MSCI USA Value Large Cap Index||0.82||0.89||0.86||0.86||1.00|
|MSCI USA Value Mid Cap Index||0.84||0.89||0.91||0.92||0.94||1.00|
|MSCI USA Value Small Cap Index||0.85||0.86||0.90||0.94||0.91||0.98||1.00|
In a bid to explore the systematic drivers for North American equity long short hedge funds, we run a regression for the former against the 6 market indices we displayed in table 3. While the results are statistically significant as a whole, individual factors highlighted in red in the table below were not robust. Nonetheless, key numbers from the regression results are depicted below.
The regression was carried on monthly data from the period January 2007 to August 2017, with our objective being to explain away the performance of North American equity long short hedge funds through a combination of growth/value styles broken down across small, mid and large cap sizes.
Results – the average North American long short equity hedge fund has posted a gain of 0.56% per month since January 2007. Of this 0.32% can be explained away through exposure across growth/value styles while 0.24% is the residue or the regression alpha that could in some sense be interpreted as the average monthly alpha.
Table 4: Regression table from January 2007 to August 2017 monthly data
|North American Long Short Equities Hedge Funds|
|Avg Monthly Return (Jan 07- Aug 17)||0.56%|
|Total return from systematic risk factors||0.32%|
|MSCI USA Growth Large Cap Index||0.03%|
|MSCI USA Growth Mid Cap Index||0.10%|
|MSCI USA Growth Small Cap Index||0.26%|
|MSCI USA Value Large Cap Index||0.04%|
|MSCI USA Value Mid Cap Index||-0.09%|
|MSCI USA Value Small Cap Index||-0.02%|
Figure 3 places the results of our regression in perspective making them more intuitive to understand. The chart essentially shows the return accruing from exposure to the systematic risk factors and breaks it down across growth/value and small, mid and large cap sizes. At a glance it should become obvious to the reader that the bulk of the tilt to returns comes from the exposure to growth factor, with 0.26% of the return being attributable to small cap growth styles, followed by 0.10% to mid-cap growth styles with a relatively smaller attribution coming from value style of investment.
Figure 3: Drivers of systematic returns for North American long short equities hedge Funds
The last chart shows the trend underpinning not just the North American hedge fund space but the global hedge fund industry as whole. Following a tough market environment in 2016, when investors withdrew US$22.7 billion from North American hedge funds alone, things are starting to reverse, and for a lack of better words, quite ‘bigly’. As of August 2017 YTD, North American hedge funds have attracted US$50.1 billion in net investor inflows – the strongest flows on record since 2013. However, with concerns of stretched valuations in the equity markets and a central bank still grappling with the idea of a well-timed and well executed rate hike, it remains to be seen how long these positive trends continue.
Figure 4: Capital flows into hedge funds - a ‘fantastic’ reversal
Head Analyst - Eurekahedge
Hedge Fund Research & Indexation