Index performance analysis gives strategy perspective

In a recent report (V Le Sourd, February 2009, Hedge Fund Performance in 2008, EDHEC Publication) an analysis of 12 years of data on EDHEC Alternative I for different hedge fund strategies provided some perspective on their performance.

Funds of hedge funds lost 17% in 2008, posting their worst annual returns since we began keeping records in 1997, and hedge fund investments lost value across the board. Except for CTAs and short sellers, all strategies posted their worst losses in 2008.

Even after the impact of a calamitous year, half the strategies still post-cumulative returns above 100% for the past 10 years, that is, a compound annual return above 7%. Interestingly, distressed securities funds and emerging markets funds are the strategies that have the highest return over the past 10 years, even though they were among the biggest losers, with returns of -19% and -30% respectively in 2008. Short sellers have the lowest 10-year returns of all the strategies, even after returning 25% in 2008.

In 2008 investors were given a painful reminder that hedge funds are exposed to a variety of risk factors, such as credit risk, liquidity risk and several equity risk factors. Historical estimates of volatility and value-at-risk now suggest greater risk for hedge funds as risk measures have increased across strategies when taking into account the data for 2008.

Market environment
The S&P 500 fell 37% in 2008, the greatest one-year fall for the period since data has been available (1964). Most of this fall took place in the last months of the year as news of the worsening financial crisis spread. In October alone the S&P 500 lost about 17%. Heavy losses were also observed in September (about 9%) and November (7%).

Losses such as those of October 2008 are extremely rare and are greater than any that have been observed in the last decade. For example, during the Russian crisis of August 1998, the S&P 500 fell 14.5%. In September 2001, it fell about 8% and one year later, in September 2002, about 11%.

The veritable plunge of stock markets in 2008 comes on the heels of fair performance - a total return of 5.49% for the S&P 500 - in 2007. At the end of December 2008, the index was at its lowest since September 2003.

The volatility of returns was also considerably higher in 2008 than in 2007, with a standard deviation of 21.02% of the S&P 500 monthly returns, compared to 9.66% in 2007 and to 5.64% in 2006, a year in which we observed the lowest volatility of the decade for the S&P 500 index, together with good performance of about 16%. The volatility observed in 2008 is nearly as high as any since 1997, and comparable to that of 1998, 2001 and 2002, years of turbulent stock markets.

Emerging markets were hit with even greater losses. For example, the S&P IFCI Index, which includes 22 emerging markets, fell by about 54% in 2008; this index had posted returns between 35% and 40% over the three previous years (2005-2007).

Government bonds are typically considered a safe haven in times of turbulent markets. In addition, central banks around the world cut interest rates in 2008. The government bond market thus performed well.

The Lehman Global US Treasury Bond, for example, posted returns of 13.74% higher than the 9.01% returns of 2007. After the substantial 40% progression of 2007, commodity prices fell considerably - by about 43%, to April 2005 levels, as measured by the S&P GSCI Commodity Spot Index.

Hedge fund return analysis
All hedge fund strategies, except for CTA global and short selling, posted negative returns, and all these negative returns were their worst since the 1997 creation of the indices. Not once since 1997 have so many strategies (11) posted such deeply negative returns at the same time; previously, no more than three strategies had been in the red in any one year.

Funds of hedge funds, which are sometimes taken to give an aggregate view of the industry's performance, performed very badly in 2008, with a strong negative average return of -17.08%, the first time since 1997 that this index has posted negative returns.

The months of September and October were the major contributors to the negative performance for all the strategies. But other months contributed as well, as most of the strategies racked up more negative than positive months; indeed, six strategies (convertible arbitrage, distressed securities, emerging markets, event-driven, fixed-income arbitrage, and funds of funds) posted negative returns for as many as nine months in 2008.

December, on the contrary, provided an opportunity for a slight recovery for the majority of the strategies, as only five posted negative returns (distressed securities, emerging markets, event-driven, short selling, and funds of funds). Unlike the other strategies, CTA global and short selling posted not only positive but also strong returns, only slightly lower than their best annual returns since 1997.

The best-performing strategy was short selling, with a return of 24.72%. The lowest return (-30.30%) was obtained by emerging markets, closely followed by convertible arbitrage (-26.48%).

Five of the strategies (convertible arbitrage, distressed securities, emerging markets, fixed-income arbitrage and funds of funds) now present a negative average return for the period from 2006 to 2008, and only four (CTA global, global macro, merger arbitrage and short selling) have produced an average return above 5% for this same period.

Only the two strategies that performed positively, CTA global and short selling, present higher average performance for this recent three-year period than for the last 10 years. All other strategies, except merger arbitrage, have done considerably worse over the short term (the past three years) than over the long term (the past 10 years). The short-term performance of merger arbitrage is only slightly worse than its long-term performance.

The volatilities of the strategies, as shown by figures higher for the last three years than for the last 10 years, have increased recently. Only for CTA global and short selling is volatility higher over the long term than it is over the short term.

For the period 2006 to 2008, volatility figures range from 4.42% for merger arbitrage to 13.73% for emerging markets. For the 10-year period the range is wider, from 3.17% to 17.74%, with the low observed for equity market neutral and the high for short selling. In view of these results, the best Sharpe ratio for the period from 2006 to 2008 is that of CTA global. This strategy also had the best Sortino ratio.

Only four strategies had positive Sharpe and Sortino ratios (CTA global, global macro, merger arbitrage and short selling). The lowest Sharpe ratio and the lowest Sortino ratio are exhibited by convertible arbitrage.

Over the 10-year period, all Sharpe ratios are positive, except for that of short selling, which is only slightly negative; all Sortino ratios are also positive. Over this longer period, the highest Sharpe ratio value is posted by merger arbitrage; the highest Sortino ratio is posted by global macro.

Methodology
The EDHEC Alternative Indices were used to measure the performance of hedge fund strategies and their exposure to major risk factors. These indices of indices have the merit of being by construction more representative and more stable than the hedge fund indices available on the market.

With hedge fund strategies showing significant extreme risks, we have decided to present three risk-adjusted performance indicators that take these risks into account. The adjusted Sharpe ratio, for example, involves replacing the volatility in the denominator of the traditional Sharpe ratio with the modified value-at-risk.

The Sortino ratio divides the return of an asset over a pre-specified threshold (the minimum acceptable return is equal to 2.5 in our case) by the downside risk of this asset.

By Veronique Le Sourd, senior research engineer, EDHEC Risk and Asset Management Research Centre.