Hedge Funds and the Case of the Missing Alpha
The first quarter of 2016 was a rollercoaster period for markets. While mid-February saw equities down significantly, there followed a significant rally leading many major indices except Europe and Japan to finish the Q1 in positive territory. Equity long/short managers, who seek to identify stocks that they think will rise and fall, struggled significantly during this time, leading one prime broker to refer to the quarter as the “worst period of manager alpha for equity long/short for seven years.” Clearly something significant was happening, but what?
Although equity long/short managers hope to make money on both the long and short sides of their book, if one fails to perform, the other usually provides some protection. But the last quarter was notable in that globally, many hedge funds experienced both long and short negative alpha. Overall the long book was painful, but the short book also detracted.
In our view, there were three key interlinked dynamics that help explain why the period was so difficult for alpha1 generation.
- Market rotation at a style and factor level, in particular the underperformance of momentum.
- Sector rotation, i.e. those areas of the market such as energy and mining, which had underperformed over 2015, rallying significantly.
- General crowdedness across the investment universe which unwound, causing painful adverse price movements for portfolios.
Factors and style are specific attributes of securities (such as market cap size, or increasing momentum in price, or a particularly low book-to-price ratio). There was a significant change in the performance of factors such as momentum over the period versus 2015. The Goldman Sachs Equity Momentum Global Long-Short index (which goes long the top 20% of stocks with the greatest 12 month positive price momentum and short the bottom 20% of greatest negative momentum stocks) fell -5.16% in USD over Q1 ’16, after returning +13.33% over 2015. At a style level, we also saw a reversal of growth and value, with the S&P 500 Growth index underperforming the broad S&P 500 index by -0.8% in USD over Q1 (after outperforming by 4.1% over 2015) and the S&P 500 Value index performing in mirror fashion (underperforming by 4.4% in 2015 and outperforming by 0.8% over Q1). Managers who had done well over 2015 and who had tilts towards momentum and growth were hurt as this trend reversed.
Sectors also rotated during the quarter. Many managers had come into the year with shorts in certain cyclical sectors due to fundamental assessments on the macro and micro unattractiveness of these stocks and were hurt as these names rallied. Conversely their longs in higher-quality, higher-growth or defensive companies caused the long book to underperform. The chart below provides a summary of European equity sector returns since the market lows of 11th February to mid-March.
Figure 1: Relative Sector Performance from February 11-April 30, 2016
Source: UBS European Equity Strategy
The final dynamic was the extent of hedge fund crowdedness. There has been a lot of talk about deleveraging by major hedge funds over Q1, as well as the extent of short covering. When there is a high degree of hedge fund investment in the same stocks on the long, and particularly short side, any reduction of risk by selling longs and covering shorts can exacerbate price action. One hedge fund manager commented that some of the most shorted baskets had a series of record up days in February and March in Europe and the US. The two charts below illustrate the impact of this dynamic. The first shows that the Goldman Sachs VIP hedge fund US longs (the most popular holdings of hedge funds) underperformed the S&P500 (-4.5%) while the VIP shorts outperformed the index (+2.2%). The second shows how stocks with the highest HF ownership as a % of common shares outstanding significantly underperformed stocks with the least HF ownership (-0.8% versus +7.6%, on a market return of +1.3%).
Figure 2: Goldman VIP longs vs. shorts (Q1 2016)
GSTHHVIP: basket of the 50 S & P 500 stocks that appear most frequently among the top 10 holdings of fundamentally-driven portfolios.
GSTHVISP: basket of the 50 S & P 500 stocks that appear most frequently among the top 10 shorts of fundamentarlly-driven portfolios.
Past performance is not indicative of future results.
Figure 3: Goldman Most vs. Least Concentrated Longs (Q1 2016)
GSTHHFHI: Index of 20 stocks in the S & P 500 with the highest percentage of hedge fund ownership.
GSTHHFSL: Index of 20 stocks in the S & P 500 with the lowest percentage of hedge fund ownership.
Past performance is not indicative of future results.
Could managers have seen this coming? Perhaps. Anecdotally we have found many managers were aware of the risk in their long books (particularly those who had had a stellar 2015) but either didn’t want to cut winning ideas in which they still had significant conviction, didn’t see a bear market scenario where value stocks did well, or simply thought the only sensible place to have any sort of bias was to growth ideas in a low GDP growth world (and inversely against stocks with structurally-challenged markets). There were not many true contrarians who saw fundamental opportunities in mining or oil stocks and those who did had tended to be early and suffered in 2015 as a consequence.
In response to losses, many managers derisked their portfolios over the quarter by taking down their total level of gross (i.e. portfolio exposure on the long and the short book). However, while they reduced overall risk in terms of exposure, many managers have not changed their fundamental tilts. While they are strongly apologetic about recent returns, most are sticking to their views.
Finally, given what has been seen in terms of market leadership so far this year, it is worth considering whether the recent value rally is a short-term technical move or if it marks a more fundamental opportunity. In our view, it is hard to see a sustained period of value outperformance unless there is a significant improvement in the fundamental macro outlook and/or a significant pick-up in inflation. Value does not tend to be an attractive fundamental trade at this point in the business cycle. The events of Q1 and April may have reflected a washing out of crowded positions and a degree of short covering.
That said, recent market volatility has thrown up some interesting stock-specific value opportunities, both within sectors and in certain segments of the market (i.e. valuation differentials between more defensive sectors). This should present opportunities for skilled stock-pickers in the future.
1 Alpha is a risk-adjusted performance measure, comparing the price risk of a fund and the risk-adjusted performance of its benchmark. Positive alphas represent outperformance of the benchmark, while negative ones represent underperformance.
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