October is turning out to be a historically dismal month for equity long/short hedge funds. As of October 31, 2018, Goldman Sachs reported that fundamental long/short equity funds were down 7.4% month to date when the MSCI World and S&P 500 were down 7.3% and 6.8%, respectively. Thus, despite a net market exposure of approximately 0.4, long/short hedge funds essentially lost as much money as the overall markets – or two and half times as much as predicted.
October’s performance highlights two underappreciated risks in equity long/short funds:
- Popular hedge fund stocks often perform terribly during down markets.
This is not a recent phenomenon. The Goldman Sachs VIP index, which tracks the most “important” stocks in hedge fund portfolios, underperformed the S&P 500 by around 800 bps in 2008, 600 bps in 2011, 400 bps in 2014, and a stunning 1000 bps in 2015-16. The most compelling explanation is that when markets get ugly, funds start liquidating crowded trades. Alternatively, sensing weakness, other investors aggressively sell the stocks in anticipation of hedge fund liquidations (as far back as the 1990s, Wall Street trading desks would regularly circulate lists of stocks by hedge funds that were in trouble – US Air and Tiger Management comes to mind). Arguably, this problem has become worse in recent years as large hedge funds grew larger, and new fund offshoots followed similar strategies as their forebears. Another factor is the growth of copycat investors who study 13F and 13D filings to piggyback on positions held by famous hedge fund managers – those investors who appear more likely to sell at the first sign of trouble (Pershing Square’s Valeant position in 2015 is a prime example).
- Hedging really is a form of leverage.
A typical hedge fund might own $100 of long positions hedged with $50 of shorts. In stable market conditions, the shorts dampen volatility, and if good stock picking causes the longs to outperform the shorts over time, the fund generates alpha. Those shorts, on the other hand, are a form of leverage: the gross (long plus short) exposure of the fund is 150%. This leverage can amplify losses when shorts outperform longs. October is a prime example of this. Goldman also publishes an index of Very Important Short positions, a good proxy for what hedge funds are shorting, and those stocks were down only around 5% through October 31, or 325 bps less than popular longs, which were down 8.0% (over 100 bps worse than the MSCI World and S&P 500). To put some math on it, using the Goldman Sachs VIP indices, a typical hedge fund lost 8% on its longs, but gained back only around 2.5% (50% x 5%) on its shorts, and hence lost 5.5% month to date.
Fundamentally driven equity long/short funds often have very different kinds of stocks in their long and short portfolios. A fund that has been bullish on tech might be bearish on industrials. This introduces something called “factor” risk – the risk that different sectors of the market will behave very differently at different times. Between leverage and factor tilts, equity long/short funds often have periodic drawdowns that are far higher than the term “hedge” would imply. For instance, over the five years to the end of 2017, the average equity long/short fund had net market exposure (beta) of around 0.4. The maximum drawdown of the S&P 500 over that period of time was 8.4%, which should equate to an average drawdown among the funds of 3-4%. Instead, the average maximum drawdown of a sample of almost 500 funds was a staggering 18%. Leverage obviously cuts both ways. What makes October interesting is that so many funds appear to be getting hit at the same time. This month could be one for the record books.
One question we hear often is why hedge funds performed so poorly during 2008. Equity hedge fund indices, which typically has a beta of around 0.4, should have lost around 15% in 2008 when the S&P declined 37%. Instead, the index lost 27%, or 73% of the S&P’s decline. The principal explanation is that their longs materially underperformed their short positions. By contrast, in 2000-2002, tech shorts went down much more that value mid cap stocks, and hence the same types of hedge funds walked away relatively unscathed as the S&P dropped 45%.
For investors in equity hedge funds, the recent poor performance raises a troubling question: if the hedges fail to work in down equity markets – precisely when they are most needed – then these funds have questionable value in a diversified portfolio. A key due diligence question is for allocators to precisely understand issues around trade crowding and, as importantly, factor tilts to be able to correctly anticipate how a given fund should perform in various market regimes. While some funds will be positioned to protect capital in a month like this, most will not – something allocators should make a due diligence priority.