Risk exposure stalls growth
As can be seen from table 1, the main hedge fund strategies all fell short of their long-term average performance in March. Three of the five strategies, namely convertible arbitrage, long/short equity and event driven, even posted negative returns.
These disappointing returns might be explained by the exposure of hedge fund strategies to a set of risk factors. Some of these are common to all the strategies. The decline in the stock markets (-1.91% for the S&P 500) together with the increase in credit risk (credit risk increased by 23.3%) not only hampered the performance of long/short equity and event driven funds directly, but also contributed to creating a hostile environment for funds following non-directional strategies (eg, convertible arbitrage and equity market neutral).
Other factors affected one or more strategies in a specific way. In particular, long/short equity, event driven and equity market neutral funds suffered from the strong decrease in the size spread (the outperformance of the S&P 600 small cap index over the S&P 500 index was -0.7% in March as opposed to 0.9% the previous month) and the steepening of the yield curve.
In the same vein, the decline in bond markets (-0.9% for the LGBI) hampered the performance of CTA global funds.
Conversely, thanks to the increase in short-term interest rates and the rise in the implied volatility of the stock markets (+16% for the VIX), equity market neutral funds succeeded in posting (slightly) positive returns. However, in spite of the increase in the implied volatility of the stock markets, the widening of the credit spread, and the rally in the commodities markets (+7.8% for the GSCI), CTA Global funds were not able to achieve satisfying performance in March.
Mathieu Vaissié, research engineer with the Edhec Risk and Asset Management Research Centre
Edhec methodology used
We used the Edhec Alternative Indices to measure the performance of hedge fund strategies and their exposure to major risk factors. These indices of indices have the merit of being by construction more representative and more stable than the hedge fund indices available on the market (see www.edhec-risk.com for more details). On the other hand, with hedge fund strategies showing significant extreme risks, we present three risk-adjusted performance indicators taking account of this specific feature. The adjusted Sharpe ratio, for example, involves replacing the volatility in the denominator of the traditional Sharpe ratio with the modified value-at-risk. The Sortino ratio divides the excess return of an asset over a pre-specified threshold (the minimum acceptable return is equal to 2.5% in our case), by the downside risk of this asset. Finally, the omega ratio involves dividing the probability weighted average return of an asset over a pre-specified threshold by the probability weighted average return of this asset below the same threshold.
For the sake of clarity, we only report correlation coefficients when factors appeared to be significant. These factors were identified as follows. In an attempt to highlight their true economic exposures to risk factors, we first corrected the hedge fund strategies’ historical return series for auto-correlation, following the iterative unsmoothing procedure introduced in Okunev and White (2004). We subsequently regressed hedge fund returns onto every single risk factor, and selected the ones showing co-efficients that were significant at a 95% confidence level. We finally calculated the correlation co-efficient of hedge fund strategies with the selected factors.