The S&P 500 Index (SPX) has enjoyed a strong run. However, it has endured some big declines as well.
Since January 1997, the market has gained over 230% or an annualized gain of more than 8% per year. Those investors who that follow the “buy and hold” strategy have certainly felt pretty good about their investments over the past 17 years, though there have been peaks and troughs, depending on the time frame.
Hedge funds are private pools of capital fun by managers who use risky strategies to outperform the market. Most hedge fund strategists will explain that they seek to minimize risk. They also tend to suggest that they try to participate in the market when times are considered good, and will aim to protect when times are bad.
Generally the objective is to participate in 70%-80% of the upside of the market while limiting losses to 30% to 40% of the time during down periods and reducing the impact of the market’s volatility by half.
What does this mean? If the S&P were to rise 10% in a particular month, a hedge fund strategy with this approach would ideally aim to gain 7% or 8%. Conversely, should the market go down 10%, a hedge fund manager might be happy being down 3 or 4%.
And when looking at volatility, as measured by the standard deviation of its returns, one could expect a hedge fund to have a standard deviation of say 5 when the market was 10.
If we were to capture 70% of the upside of a particular month and limit any down month to roughly 40% of that loss, what would a $1000 investment on January 1997 be worth today?
Well, a $1000 investment in the S&P would be worth over $3,300 while the 70/40 capture might be closer to $6,000. The standard deviation of the S&P would be about 15 while the 70/40 would be less, at about 9. This, I imagine, would be an acceptable result.
There are several different indices that track hedge fund performance. They measure overall performance as well as individual strategy performance returns.
Dating back to January of 1997, the Barclay Hedge Fund Index, (unaffiliated with Barclay’s Bank) measures returns from all strategies across thousands of different hedge funds.
A $1,000 investment in this index in 1997 would have grown to over $4,700 versus $3,300 in the S&P. This represents approximately a 60% capture of the up months and 35% capture of the months the S&P was down. This was achieved with a standard deviation of about 7.5, more than half that of the market S&P.
So, the notion that hedge funds are speculative and risky doesn’t seem evident here. In fact, if anything, they would seem to be less risky, almost defensive, focusing on limiting the downside and paying for that protection by taking part a little less with the upside.
DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Index returns do not reflect any management fees, transaction costs or expenses. Individuals cannot invest directly in an Index. Past performance is no guarantee of future results.
