Index and Derivatives Perspective
When do hedge fund managers add alpha?
Sandy Rattray
New York: 212-902-6825
Venkatesh Balasubramanian
New York: 212-855-0053
The returns of hedge funds are more difficult to analyze than the returns of long-only
managers, most notably because the quality of hedge fund indexes tends to be lower.
That said, an analysis of the CSFB/Tremont Hedge Fund Indexes shows that some of
the same factors that explain long-only asset manager returns have remarkably high
degrees of statistical significance when used to explain hedge fund returns.
Originally published:
July 24, 2003
Our main conclusions are:
Updated: March 1, 2004
• The level of cross-stock dispersion matters for long/short and market neutral funds,
and has recently become the most important explanatory variable. Just as with long
only managers, the influence of dispersion has become much greater recently, and
has moved from being a negative to a positive influence. A high level of stock
dispersion is currently good for these types of managers.
• Moves in the equity market influence the returns of long/short funds and market
neutral funds. Long/short funds successfully played the bull and bear markets by
being net long and net short in each environment. Market-neutral funds had long
exposure in the bull market (probably though overweight high beta names) and have
become truly market-neutral in the bear market.
• The performance of small-cap stocks relative to large-cap stocks has a positive
influence on long/short funds, perhaps because they short a small number of mostly
large-cap names.
• Global macro funds are sensitive to the dispersion between global equity market
indexes and the correlation between equities and bonds.
We use the same analytical framework as in a previous analysis of long-only managers;1
specifically, cross-stock dispersion, a value tilt, small-cap tilt and market return (in
excess of cash). The last three factors are Fama-French factors. Lastly, we use
measures of cross-index dispersion and equity/bond return correlation to examine the
returns of global macro funds.
Long/short funds
Exhibit 1 shows that long/short funds have generated an average monthly return of
1.02% (net of fees) since 1994. The chart also shows how much the different factors
have contributed to the monthly return. The segments of the bar chart that have a dark
blue line to the right are statistically significant at the 95% level – they are the most
reliable outputs to this analysis. Over the last five years, the four factors explain around
75% of the return of the average long/short manager.
1
See When do active equity managers add alpha?, Joanne M. Hill and Ingrid Tierens, Goldman
Sachs Equity Derivatives Strategy, Updated March 1, 2004.
Goldman Sachs Equity Derivatives Strategy
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Index and Derivatives Perspective
Exhibit 1: Long/short funds: Factor contribution to average monthly return shows
cross-stock dispersion now dominates
Average Monthly Contribution (%)
2
R2
74%
84%
1.11
75%
0.93
1.02
1
0
Cross-stock dispersion level
Value tilt
Small cap tilt
Market coefficient
Unexplained (intercept)
-1
Overall Period
1994-1998
1999-2004
Indicates statistical significance at the 2-standard deviation level
NOTE: Monthly data from January 1994 to January 2004.
Source: Goldman Sachs, CSFB/Tremont Hedge Fund Indexes and Fama-French.
•
The level of cross-stock dispersion has moved from having a (surprisingly) negative
impact to a positive impact in the most recent five-year period. (The average level
of dispersion increased between the 1994-1998 and 1999-2004 periods.) Over the
last five years, the level of cross-stock dispersion has been the factor that accounts
for the largest portion of average long/short fund returns.
•
The market return has been consistently statistically significant as a contributing
factor. Long/short funds appear to have navigated the move from a bull to a bear
market and the subsequent rally quite successfully, with relatively little negative
influence from the 2000-2002 bear market.
•
Funds are exposed to small-cap relative to large-cap returns, perhaps because they
short mostly large-cap stocks.
Market-neutral funds
Our analysis of market-neutral funds shows broadly the same factors are at work as for
long/short funds. The percentage of returns that we explain is lower, however, at only
23% in the 1999-2004 period. This may be in part because the market return is a
predictable and important factor for long/short funds, but not for market-neutral funds.
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Goldman Sachs Equity Derivatives Strategy
Index and Derivatives Perspective
Exhibit 2: Market-neutral funds: Factor contribution to average monthly return shows
cross-stock dispersion dominates here also
2
2
Average Monthly Contribution (%)
R
1
15%
34%
0.84
23%
0.86
0.85
0
Cross-stock dispersion level
Value tilt
Small cap tilt
Market coefficient
Unexplained (intercept)
-1
Overall Period
1994-1998
1999-2004
Indicates statistical significance at the 2-standard deviation level
NOTE: Monthly data from January 1994 to January 2004.
Source: Goldman Sachs, CSFB/Tremont Hedge Fund Indexes and Fama-French.
•
Cross-stock dispersion has moved from being a negative contributor in the 19941998 period to being a positive contributor recently. Cross-stock dispersion has
become by far the most important variable in explaining the returns of marketneutral funds in the recent period.
•
The market return had a positive contribution to long/short funds’ performance in
the 1994-1998 period. More recently funds have, on average, totally immunized
their returns from market movement.
Global macro funds
Global macro hedge fund performance is harder to explain than long/short or marketneutral manager performance. This may, in part, be due to the CSFB/Tremont index
having a smaller number of hedge funds and also missing some of the largest macro
players in the index. To analyze global macro fund performance, we have replaced
cross-stock dispersion with cross-index dispersion, and added a variable that measures
the correlation between equity and bond market returns. We explain a relatively
modest 20% of monthly returns using these variables.
•
The correlation between equity and bond returns was a positive contributor
throughout both 1994-1998 and 1998-2004. More recently, the correlation
between equity and bond returns has been negative, reflecting greater opportunity
to profit between equity and bond market returns. Perhaps surprisingly, this has
not translated into this factor providing better performance.
Goldman Sachs Equity Derivatives Strategy
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Index and Derivatives Perspective
•
Dispersion between equity index returns, which has decreased between the 19941998 period and the 1999-2004 period, has nonetheless moved from being a
negative contributor (when there were significant return differentials) to a positive
contributor (as return differentials between equity markets have diminished).
Exhibit 3: Global macro funds: Cross-index dispersion and stock/bond return
correlation are the major return contributors
10
R2
9%
31%
1.29
20%
8
Average Monthly Contribution (%)
6
4
1.10
1.20
2
0
-2
-4
-6
-8
Stock-Bond Correlation
World Index Dispersion
Value Tilt
Small Cap Tilt
Market Coefficient
Unexplained (intercept)
-10
Entire Period
1994-1998
Indicates statistical significance at the 2-standard deviation level
1999-2004
NOTE: Monthly data from January 1994 to January 2004.
Source: Goldman Sachs, CSFB/Tremont Hedge Fund Indexes, Bloomberg EFFAS, FTSE and Fama-French.
Conclusion
Long/short managers and market-neutral managers are successful as a group in isolating
their exposure to many of the variables that drive long-only active managers returns.
This appears to be true beyond the reduction of exposure to the equity market, which
seems to be quite successful across the group as a whole, and extends to relatively low
exposure to style and size factors. As a result, cross-stock dispersion has become the
dominant driver of their returns, with increasing dispersion providing an increased
opportunity set. Managers who are especially concerned about their exposure to
dispersion could consider using derivative strategies to immunize this exposure
(shorting dispersion by going long index volatility, short individual stock volatility). If
dispersion increases further as the U.S. economy shows further strength, these managers
should be well-positioned to realize positive future returns.
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Goldman Sachs Equity Derivatives Strategy
Index and Derivatives Perspective
Appendix: Regression returns
Exhibit A1: Average factor returns/levels
1994-98
1999-2004
Change
Market
Excess
Return
1.35
-0.06
-1.41
Small Cap
Tilt
-0.46
1.04
+1.50
Value
Tilt
-0.20
0.46
+0.66
World
Stock
Cross-Stock Cross-Market
Bond
Dispersion Dispersion Correlation
2.82
3.25
0.48
3.09
1.81
-0.15
+0.27
-1.45
-0.62
NOTE: Data from January 1994 to January 2004.
Source: CSFB/Tremont Hedge Fund Indexes, Fama-French and Goldman Sachs.
Exhibit A2: Long/short funds – regression outputs
Market Small Cap
Coefficient
Tilt
Entire
Beta
Period
(1994-04) t-Stat
1994 - 1998
Cross-Stock
Dispersion
+0.36
+0.17
-0.29
+0.14
+10.75
+4.04
-7.95
+0.80
+0.59
+0.26
-0.06
-0.19
+11.81
+3.99
-0.78
-0.96
Beta
+0.27
+0.16
-0.31
+0.31
t-Stat
+6.05
+2.89
-7.37
+1.23
Beta
t-Stat
1999 - 2004
Value
Tilt
NOTE: Data from January 1994 to January 2004.
Source: CSFB/Tremont Hedge Fund Indexes, Fama-French and Goldman Sachs.
Exhibit A3: Market neutral funds – regression outputs
Market Small Cap
Coefficient
Tilt
Entire
Beta
Period
(1994-04) t-Stat
1994 - 1998
1999 - 2004
Value
Tilt
Cross-Stock
Dispersion
+0.07
-0.01
+0.00
+0.06
+4.35
-0.44
+0.17
+0.66
Beta
+0.16
+0.03
+0.05
-0.26
t-Stat
+4.39
+0.69
+0.82
-1.75
Beta
+0.03
-0.02
-0.00
+0.27
t-Stat
+2.43
-1.04
-0.04
+3.38
NOTE: Data from January 1994 to January 2004.
Source: CSFB/Tremont Hedge Fund Indexes, Fama-French and Goldman Sachs.
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Index and Derivatives Perspective
Exhibit A4: Global macro funds – regression outputs
Market Small Cap
Coefficient
Tilt
Entire
Beta
Period
(1994-04) t-Stat
1994 - 1998
1999 - 2004
World
Value Cross-Market Stock / Bond
Tilt
Dispersion
Correlation
+0.16
+0.01
-0.05
-0.40
+0.97
+2.21
+0.16
-0.59
-1.54
+0.90
Beta
+0.41
-0.37
+0.00
-0.69
+17.61
t-Stat
+2.63
-1.75
+0.01
-2.13
+3.40
Beta
+0.03
+0.12
-0.10
+1.06
-2.63
t-Stat
+0.64
+1.71
-1.76
+1.17
-1.92
NOTE: Data from January 1994 to January 2004.
Source: CSFB/Tremont Hedge Fund Indexes, Fama-French and Goldman Sachs.
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Goldman Sachs Equity Derivatives Strategy
Index and Derivatives Perspective
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