The Way Forward for Hedge Funds – 2

In the first installment, I made a case that hedge funds can regain their popularity by reverting to their initial mandate which was to be hedged. I examine here how such a model hedge fund would have performed in the past 50 years if it had returned:

  • 0% in all years when the market was down.
  • 75% of the market gain in all years when the market was up.

In essence, this fund only has a chance of outperforming the S&P 500 in the long run if the market has a big down year (say 10%+) every few years.

So what do the past 50 years tell us?

The results are not consistent across all the decades. Such a fund underperformed the S&P 500 in the 1980s and 1990s but it outperformed in the 1970s and 2000s. The reason for the 1980s and 1990s shortfall is that there were only two down years for the market, 1981 and 1990, and both were very mild declines, at -4.9% and -3.1% respectively. Of course, there was the crash of 1987 but the market ended that year with a gain of 5.3%.


By contrast in the 1970s, the S&P 500 was down 14.7%, 26.5% and 7.2% in 1973, 1974 and 1977. And in the 2000s, it was down 9.1%, 11.9%, 22.1% and 37% in 2000, 2001, 2002 and 2008. Each of these years gave the hedge fund a chance to outperform the benchmark S&P 500.

In The Lottery of Birth Place and Time, I wrote that the course of a person’s life is largely determined not only by the place but also by the year of their birth. The same appears to be true for a fund, as shown in the table below. A hedge fund created in 1966 that performed per our model would have fared much better relative to the index than a similar fund created in 1976. The first fund lived through the bear markets of the late 1960s and early 1970s and had a chance to outperform in those years. The second fund encountered few bear markets in comparison and was stuck lagging a bull market year after year, though it had almost pulled to even with the S&P 500 after year 35 in 2010 due to the market debacle of 2008.

To illustrate how this table was compiled, $100 invested in the S&P 500 in 1966 had turned into $10,117.1 after 50 years in 2015 (assuming that dividends were reinvested), while $100 invested in our model hedge fund would have turned into $13,366.7. The difference $13,367 – $10,117 = $3,249.6 is shown in the table in the 1966 column and 50 row.

(click to enlarge.)

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The numbers shown in red denote the hedge fund’s underperformance and cover the 1980s and 1990s when the bull market was nearly uninterrupted. No surprise then that the biggest underperformance was after a cumulative 25 years for a fund started in 1976, shortly after the Nasdaq bubble.

As the bull market years fall away in the table for funds started in 1996, 2001 and 2006, the  model hedge fund would have done better than the index, due to the bear markets of 2000-02 and 2008.

To hedge or not to hedge

So, going forward in the next decade, will the profile of the S&P 500 resemble more the 1980s and 1990s or the 1970s and 2000s? Making this judgment call would help decide whether it is better for a fund to be fully long or to be hedged.

Here are the possible scenarios:

  1. Market as strong as the 1980s and/or 1990s with only minor corrections along the way.
  2. Market as weak as 1970s and/or 2000s with one or several big down years.
  3. Market plodding along with small single digit gains or losses every year. This scenario would be an extension of 2015 and so far 2016.

Scenario 1 would compel a hedge fund to be fully long at all times but this scenario is unlikely in my view. Many factors propelled the 1980s economy and are not at play today. I discussed them in Would Reaganomics Work Today?

Scenario 2 would lead a hedge fund to be hedged and to get its alpha from the years when the market is down. Over a prolonged period, such a fund would beat its benchmark with less volatility. This is the most probable scenario, given the challenges faced by the economy, in particular the aging of the US population and the softening of BRIC economies.

Scenario 3 would be problematic because it would be difficult for a fund with its high fee structure to beat the S&P 500. In my view, given the historic volatility of the market, this scenario is less likely than scenario 2.

In conclusion, this is probably a good time to run a hedged fund and to gain momentum against the index in its down years.

Read the first installment: The Way Forward for Hedge Funds – 1

(photo: Midtown Manhattan, Copyright © 2016 You may use freely with proper attribution).