What is an Investment in Hedge Funds?

With the equity market selling off broadly in May, it should come as no surprise that hedge funds also underperformed across the board...



Why?

They have historically exhibited a very strong relationship to equities (especially in recent years when the level of assets managed have spiked). The chart below shows the relationship between the S&P 500 and the broad Barclay Hedge Fund Index (i.e. not just the 'equity long bias' sub-sector index) going back 10 years.



What hedge funds have been able to do (as can be seen above) is "hedge" some of the downside risk through diverse allocations outside of traditional asset classes, while maintaining the "upside" beta to equities when equity markets have rallied. As a result, rather than pure absolute return vehicles (very few are), hedge funds can simply be thought of as very good deep value equity managers (that can also diversify into other asset classes).

Case in point... through the art of data mining, I found a fund (the First Eagle US Value Fund [FEVAX]) with a strong 9 year track record. I am not vouching for this fund, I do not own this fund, and I have not researched this fund thoroughly (though I do have a TON of respect for Bruce Greenwald, the director of research of the fund), but for this exercise simply note that it has performed exceptionally well (and very in line with the broader Barclay Hedge Fund index) since its October 2001 inception.

Returns of Barclay Hedge Fund Index, First Eagle US Value Fund, S&P 500



What's my point?

The hedge fund world has gotten so large that there is no way that all (or even most) provide consistent pure 'absolute ' return or even exhibit low correlation to equities. As the hedge fund universe grows and becomes a larger part of the broader market, it becomes increasingly difficult to do.

Instead, the broader hedge fund community should admit what they are... managers of equity beta that have outperformed significantly over the years in part by being able to take a longer view on their investments than a daily liquidity fund, in part by not having to manage to an under-performing benchmark, and in part by being exceptional managers of the equity asset class.

Source: Barclay Hedge / Yahoo