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Hedge Fund Exceptionalism In A Year When Red Was The Standard

Mon, 12 Nov 2012 12:45:11 GMT

Last year was tough for hedge funds. Put simply, 2011 was the second worst performance year on record for the average hedge fund since 1996.  Though the average hedge fund suffered substantial losses in 2008, the case could be made that it actually hedged, since it fared better than most major market indices. But while some key market indices ended 2011 flat or in slightly positive territory, the average hedge fund finished the year down.

Pundits were questioning what value a fee-charging manager that underperforms the market could possibly bring to a client. Stories in the press told of huge losses by some of the most well-known managers and of scandals and subsequent fund closings. The competing investment industry participants criticized hedge funds as not living up to their namesake. But did all of these gloomy reports lead us to forget the positives in 2011?

By merely trumpeting the negative events of 2011 and not taking a deeper dive at some of the year’s exceptions to the norm, our idea of the hedge funds industry may be distorted. Perhaps a quick look into these exceptions to the norm will provide some balance.  

The table below presents the average monthly performance and risk statistics for the top performance deciles of hedge funds based on their AUM sizes in 2011.[i]  As shown, the average hedge fund within the top deciles provided strong, double-digit returns. 

 

Top performance deciles of funds by AUM size in 2011

 

The average small fund within the top decile of performers exhibited outstanding risk-adjusted returns. Using a 0.10% risk-free rate of return, which is the annualized compound return of Merrill Lynch 3-month T-Bills for 2011—the small funds’ Sharpe ratio of 8.47 was 6.75 points higher that of the average mid-size fund and 7.18 points higher than the average large fund. In other words, a portfolio that contained the average small hedge fund within the top decile of performers in 2011 would have achieved a superior return for the additional volatility it brought to the portfolio relative to the “riskless” T-Bills.

The average mid-size fund within the top decile of performers showed the highest consistency of returns around its mean while producing a 14.74% cumulative return. The monthly standard deviation of 2.23% for mid-size funds was 0.70 percentage points lower than that of the average small fund and 0.07 percentage points lower than that of the average large fund. The average mid-size fund also showed the lowest variability in its monthly returns during periods of a loss.   

The average large fund within the top decile of performers had a cumulative return of 13.98% in 2011, which was far better than some major market indices. The table below shows the performance of the average large fund within the top decile of performers relative to four major market indices:

 

Average Large Fund within the Top Decile of Performance

 

The average large fund returned 11.87 percentage points more than the S&P 500 TR Index, 19.53 percentage points more than the FTSE 100 Index, 31.32 percentage points more than the Nikkei 225 Index, and 33.95 percentage points more than the Hang Seng Index.

While the cumulative return of the average large fund is the lowest among the three size categories, it is important to mention that the average large fund within the top decile of performers managed $2.98 billion at the beginning of January 2011 and over $3 billion by the end of December 2011. This is a significantly larger asset pool than the average mid-size and average small fund managed: the average mid-size fund within the top decile of performers managed $220.6 million at the beginning of January 2011 and $235.5 million at the end of December 2011, while the AUM of the average small fund was under $25 million during the same period.   

Each top decile size group had its own strengths in 2011:

  • The average small fund possessed robust returns with a strong risk-adjusted figure;
  • The average mid-size fund maintained a relatively low volatility profile;
  • The average large fund generated superior returns relative to major market indices while maintaining a very large asset base.

All of these funds had one thing in common as well: they were the exceptions to the norm. What these exceptions help to remind us is that there are—have been and will continue to be—hundreds of hedge funds that can provide great performance and risk statistics in a given year. Aggregate observation of an industry which includes thousands of competing hedge funds managing trillions of dollars is beneficial for directional considerations, but sometimes we have to remind ourselves that it’s also constructive to dive deeper.

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