Your SlideShare is downloading. ×
Hedge Funds’ Returns Continue to be Dominated by Beta
Upcoming SlideShare
Loading in...5

Thanks for flagging this SlideShare!

Oops! An error has occurred.

Saving this for later? Get the SlideShare app to save on your phone or tablet. Read anywhere, anytime – even offline.
Text the download link to your phone
Standard text messaging rates apply

Hedge Funds’ Returns Continue to be Dominated by Beta


Published on

Some observations by Ray Dalio\'s Bridgewater Associates on the degree to which hedge fund returns are dominated by beta and how high beta correlations are good indicators of future returns

Some observations by Ray Dalio\'s Bridgewater Associates on the degree to which hedge fund returns are dominated by beta and how high beta correlations are good indicators of future returns

1 Like
  • Be the first to comment

No Downloads
Total Views
On Slideshare
From Embeds
Number of Embeds
Embeds 0
No embeds

Report content
Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

No notes for slide


  • 1. Bridgewater ® Daily Observations October 13, 2011 © 2011 Bridgewater Associates, LP (203) 226-3030 Bob Prince Noah Yechiely Jason Rotenberg Lawrence Minicone Hedge Funds’ Returns Continue to be Dominated by Beta In the third quarter, hedge funds lost 5.5% and nearly every style index lost money1. On the one hand, you might look at this and think, of course hedge funds lost money; markets were down. On the other hand, if hedge funds were primarily alpha generators you would not expect to see this result. If hedge funds were primarily generating alpha you would expect something closer to a random outcome: an equal chance of a gain or loss in any given quarter, regardless of market direction. When you see significant losses in a down market it tells you that there is probably still a lot of beta in hedge fund returns. One of the primary appeals of hedge funds to institutional investors is the prospect of generating absolute returns, i.e., similar returns in up and down markets. However, we continue to see that hedge fund returns are dominated by beta, in particular, the return of equities. Since institutional investors already have a concentrated exposure in equities, hedge funds have not been a good diversifier. We have previously discussed our hedge fund return replication process, which closely tracks hedge fund return indices, so we won’t repeat ourselves. Suffice it to say that not much has changed. Our estimate of hedge fund returns based on the betas (i.e., passive asset class returns) contained in hedge fund strategies remains 93% correlated to the aggregate hedge fund index, and this relationship has not changed materially since 2008 when it became more apparent that hedge funds were not generating absolute returns. The first chart shows the historical and recent relationships. Hedge Fund Index Returns (Excess of Cash, Net of Fees) ; Rolling 6mo BWs Replication Portfolio ; Rolling 6mo 25% 20% Correlation: 0.93 15% 10% 5% 0% -5% -10% -15% -20% -25% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 The degree of beta in managers’ returns has remained roughly constant over time and the degree of beta has been a primary driver of their relative performance. In order to predict the future relative returns of 1 Source: Hedge Fund Research Index___________________________________________________________________________________________________________ ® ® Bridgewater Daily Observations is protected by copyright. No part of the Bridgewater Daily Observations may be duplicated or ® redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater Daily Observations is in violation of the US Federal copyright law (T 17, US code). 1 ® Bridgewater Daily Observations 10/13/2011
  • 2. hedge funds, a couple of years ago we studied the returns of 2,300 hedge funds and assessed theprevalence of beta in each manager’s returns up through June 2007, when the deleveraging began. Inthe downturn of the financial crisis, the relative returns of hedge fund managers were highly correlated tothe degree of beta which had been in their returns up until June 2007. Then, in the rally from March 2009until March of this year, the relative returns were similarly correlated to the degree of beta, except thatmore beta led to better performance. And since March the relative returns have once again been closelyrelated to the degree of beta in their historical returns, with the high beta managers underperforming. Thefollowing charts show the relative returns of hedge fund managers over these three periods as a functionof the relative amounts of beta in their returns up through June 2007. Of course, the pattern is not true forevery single manager, but it is a good indicator across the set of managers. Hedge Fund Correlation to Beta Pre-Crisis Was a Good Predictor of Performance During and After the Crisis Recent Bear Market (April 2011 – August 2011) -0.30 -0.50 -0.70 Ratio -0.90 -1.10 -1.30 0.2 to 0.3 0.3 to 0.4 0.4 to 0.5 0.5 to 0.6 0.6 to 0.7 0.7 to 0.8 0.8+ Correlation to Beta Pre-Crisis During The Crisis Bull Market (July 2007 – February 2009) (March 2009 – March 2011) -0.2 1.90 -0.4 1.70 1.50 -0.6 Ratio Ratio 1.30 -0.8 1.10 -1.0 0.90 -1.2 0.70 0.2 to 0.3 to 0.4 to 0.5 to 0.6 to 0.7 to 0.8+ 0.2 to 0.3 to 0.4 to 0.5 to 0.6 to 0.7 to 0.8+ 0.3 0.4 0.5 0.6 0.7 0.8 0.3 0.4 0.5 0.6 0.7 0.8 Correlation to Beta Pre-Crisis Correlation to Beta Pre-Crisis 2 ® Bridgewater Daily Observations 10/13/2011
  • 3. Hedge funds comprise a diverse and seemingly unrelated set of managers and it can be misleading toaggregate them all together. But even when looking at the performance of the individual style groupings,the picture is not significantly different. The following charts show that a passive portfolio of betas closelyreplicates the returns of most hedge fund styles. Convertible Arbitrage Emerging Markets Index Replication Index Replication 40% 60% 30% Correlation: 0.81 Correlation: 0.86 40% 20% 10% 20% 0% 0% -10% -20% -20% -30% -40% -40% -60% 95 98 01 04 07 10 95 98 01 04 07 10 Event Driven Fixed Income Arbitrage Index Replication Index Replication 20% 30% Correlation : 0.88 Correlation: 0.8 15% 20% 10% 5% 10% 0% 0% -5% -10% -10% -15% -20% -20% -25% -30% 95 98 01 04 07 10 95 98 01 04 07 10 Global Macro Long/Short Equity Index Replication Index Replication 50% 50% Correlation: 0.81 40% Correlation: 0.85 40% 30% 30% 20% 20% 10% 10% 0% 0% -10% -10% -20% -20% -30% -30% 95 98 01 04 07 10 95 98 01 04 07 10In the two periods of deleveraging and the one period of releveraging between 2008 and 2011, not onlywere the strategies correlated to risky assets, but they were also highly correlated to each other. Thehigh correlation is a result of the synchronous movements of risk premiums across a wide range of betas.Since most hedge fund strategies are built around capturing risk premiums, when the entire system isdeleveraging as it did in 2008, then releveraging (2009-July 2010) and then deleveraging again (ongoingsince July 2011), the correlations between the different flavors of risk premiums increase substantially. 3 ® Bridgewater Daily Observations 10/13/2011
  • 4. This is exactly the time when investors most needed absolute returns, and most hedge funds have failedto deliver. The next chart shows the rolling 24 months average correlation across the various hedge fundstyles. Average 24mo Correlation Across Hedge Fund Styles Long-term Average = 50% 100% 90% 50%-90% correlated 80% 70% 60% 50% 40% 30% 20% 10% 0% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11The next chart shows hedge funds’ risk allocation across all types of strategies. It is surprising how littlehas changed in the types of exposures underlying hedge fund strategies after the financial crisis. Hedgefunds’ aggregate degree of systematic exposure to the equity market is as high as it was in 2008. Hedge Fund Risk Exposures Dec-2008 June-2011 40% 35% 30% 25% 20% 15% 10% 5% 0% Equities Market Trend Corporate EMD Government Mortgages Market Bonds Bonds NeutralTheoretically, if hedge fund betas are replicable through passive betas, then the actual alpha captured byhedge funds is the difference between the actual hedge funds returns and the replication. Based on thiscalculation, the next chart shows the cumulative excess return of hedges (beta + alpha) and our roughestimate of the cumulative alpha return. Over the long term hedge funds seem to have created alphamore consistently than their overall returns, but it has only been about 20% of their overall ‘value’, hasbeen negative since early 2008 and was a low positive for 2010 and 2011 (roughly 3% and 0.7%respectively). In other words, most of the returns since the market bottomed in 2009 have come from therelatively permanent long exposure to betas. 4 ® Bridgewater Daily Observations 10/13/2011
  • 5. Hedge Funds Cumulative Alpha Return Hedge Fund Cumulative Excess Returns (ln) 120% 100% 80% 60% 40% 20% 0% -20% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11In what seems to be a pursuit to diversify their hedge fund portfolio and allocate money to strategies thatdid well during the financial crisis, investors poured money into trend-followers (CTAs), whoseperformance was an outlier in 2008. Currently, CTAs are the single largest hedge fund strategy withabout $400 billion in AuM, almost double their size at the end of 2008. This has reduced the aggregatebeta exposure of hedge funds, but has shifted the exposure to a bet on trending markets and increasedthe exposure to choppy markets. The following chart shows hedge funds’ performance in 2008 comparedwith new assets raised since 2009. Hedge Fund Strategy Performance in 2008 versus Investors’ Inflows into the Strategy Since 2009 [$blns] 120 100 CTAs 80 60 Emerging Markets 40 L/S Equity Global Macro 20 Fixed Income Arb. Convertible Arb. 0 Event -40% -30% -20% -10% 0% 10% 20% 30% 40% Driven -20Investors holding the ‘typical’ mix of hedge funds are exposed to and pay for a portfolio of risk premiumsand actual market neutral alpha. The combination is heavy on the former, which can be replicatedthrough a passive portfolio of risk premiums, and light on the latter. Moreover, the portfolio of riskpremiums is highly correlated to a typical institutional portfolio, and both are biased to perform well wheneconomic growth comes in higher than discounted. Not much has changed in the way hedge funds aremanaged despite the lessons that might have been learned in the financial crisis. Should this modelpersist, institutional investors are unlikely to realize the expected portfolio diversification while paying richfees for an inefficient beta portfolio, which by and large they already hold for a fraction of the cost. 5 ® Bridgewater Daily Observations 10/13/2011
  • 6. Other CountriesAustralian risks of deleveraging rising as conditions deteriorateUnlike much of the rest of the developed world, Australia’s highly indebted domestic sector was able tocontinue to accumulate debt in recent years, in large part because of the support of a substantialcommodity-exporting external sector. This is now changing, because domestic tightening is having aclear impact on household spending and housing, and because world growth is slowing and support fromexports is likely to fade. The recent drying up of global capital flows also poses risks for Australia as acapital importer, though it is too early to see any impacts on economic data. Despite a healthieremployment report on Thursday, the slowing of the economy is clear, as domestic spending is positivebut weak, consumer confidence is at recession-like levels, and home prices are falling at a 5-10% pace(and given the leverage on housing, this should at the very least be a clear negative for spending). Theexternal sector remains a clear support, but one that should slow. While growth is not yet as weak as inthe rest of the developed world and the levels of activity are not as depressed, we still believe it is likelythat debt levels have peaked and that the Australian economy will need more stimulation than isdiscounted (85bps of easing over the next year) to cushion the effects of a deleveraging. Typical easingcycles are much larger than what is discounted, and the existence of high levels of debt reduces theefficacy of a given interest rate cut, requiring more-aggressive easing and likely fiscal support.Below we show our estimates of Australian coincident growth and levels of economic activity. Growth hasclearly slowed since the tightening cycle started in the second quarter of 2009, and by our measures isnow running below potential. Levels of economic activity in Australia are modestly below normal but havebegun to deteriorate as growth has slowed. AUS 3mo Grow th AUS Output 8% 6% AUS Potential Grow th 6% 4% 4% 2% 2% 0% 0% -2% -2% -4% Output is softening Grow th remains w eak and just below -4% and below potential -6% potential -6% -8% 00 02 04 06 08 10 60 65 70 75 80 85 90 95 00 05 10A major source of slowing has been household spending and confidence. Despite the slight uptick thismonth, confidence measures have weakened considerably over the last six months and remain aroundcrisis levels. We believe deteriorating asset prices and weakening employment (despite the bounce inthe last month) are weighing on households, and thus we expect that retail sales and personalconsumption expenditures are likely to reflect further weakness in coming months. 6 ® Bridgewater Daily Observations 10/13/2011
  • 7. Real Retail Sales Q/Q (AR) Real PCE Q/Q (AR) Consumer Confidence 20% 140 15% 130 10% 120 5% 110 0% 100 -5% 90 -10% 80 Household spending is mediocre. Timely -15% 70 measures point tow ard softening demand -20% 60 00 02 04 06 08 10The recent deterioration in the housing market should serve as a net drag on demand, as the level ofhousing activity has slowed and home prices are now falling at a 5-10% annualized clip. Up-to-dateauction clearance rates (the percentage of home auctions that clear at the asking price) suggestcontinued home price weakness through the first week in October. Given the elevated leverage in theAustralian household sector (and housing leverage in particular), the impact of continued home pricedeclines poses considerable risk to the Australian economy. Negative wealth effects should impactspending even if, at least for now, the vast majority of home owners still have a lot of equity in theirhomes. RBA Home Prices q/q Ann RP Data-Rismark Home Prices q/q Ann 30% 80% Auction Clearance Rates Latest 25% 75% 20% 70% 15% 65% 10% 60% 5% 55% 0% 50% -5% 45% -10% 40% Home prices falling -15% 35% 95 97 99 01 03 05 07 09 11Relative to both GDP and disposable income, Australian household debt levels are at all-time highs andwell above those in the US - both now and prior to the recent crisis. The tightening by the RBA since late2009 has flowed through to a significant rise in debt service (due to the prevalence of floating-ratemortgages), which has succeeded in the recent stabilization of household debt levels. This is likelybehind much of the recent weakness in economic activity. The easing that is priced in implies some reliefahead, however with high debt levels and falling home prices, the efficacy of rate cuts in stimulating everhigher debt levels does have limits. 7 ® Bridgewater Daily Observations 10/13/2011
  • 8. Household Debt Levels Household Debt Levels (as % of GDP) as % of Disposable Income AUS USA AUS USA 120% 180% AUS HH debt been Australian households 160% 100% grow ing faster are highly indebted 140% than incomes 80% and have yet to 120% for more than de-lever a decade 100% 60% 80% 40% 60% 90 95 00 05 10 90 95 00 05 10 Variable Mortgage Rate HH Debt Service as % of Target Rate Mortgage Rate Disposable Income 10% 14% 9% 13% Given the forw ard path 8% 12% of interest rates, debt 11% service should fall 7% 6% 10% 5% 9% 4% 8% M o rtgage rates have risen 3% 200bps o ver the last two years 7% 2% 6% 00 02 04 06 08 10 12 00 02 04 06 08 10 12Overall, credit growth has been slowing in line with the broader slowdown in spending and decline inhousing activity. Consumer credit growth has also been soft and, while not a large number, may beindicative of deteriorating domestic demand. Net New HH Credit Creation (%PGDP, 3mma, ann.) Mortgage Consumer Total 16% 14% Start of tightening cycle 12% 10% Weakening 8% 6% 4% 2% 0% -2% -4% 00 02 04 06 08 10Employment is Now ContractingThursday’s employment report was significantly stronger than consensus expectations, as 20K jobs wereadded. While this has more than offset the losses in the last two months, employment growth has stillclearly weakened over the course of the year, and any one report will have some noise associated with it.Over time we would still expect slowing demand and slowing employment to reinforce each other, though 8 ® Bridgewater Daily Observations 10/13/2011
  • 9. the latest numbers suggest this is not yet happening at a fast pace (both demand and employment havedeteriorated but are still positive). AUS Employment m/m ann AUS Employment 3mo chg 8% Strong September print, but clear w eakening since late last year. 6% 4% 2% 0% -2% -4% Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11The unemployment rate ticked down 0.1% in September and remains near secular lows. Levels ofactivity are much less depressed in Australia than in the rest of the developed world. The deterioration ineconomic growth is recent, however. Stagnant or contracting growth will over time produce a rise inunemployment. Aus Unemployment Rate 12% 10% 8% 6% 4% 2% Rising in recent months despite the dow ntick in September, though still near secular low s. 0% 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10External Sector Support Strong but Likely to SlowOver the last decade the external sector has substantially supported Australian incomes. Since 2004,exports have risen from 6% of GDP to just below 14% today. Australia has large supplies of the bulkcommodities (iron ore, coal) that the emerging world needs for its energy- and mineral-heavy growth. Oflate, however, trading partner growth has slowed and commodity prices have rolled over, and thus weexpect that in the near term external support may slow. But recent actual export numbers have beenstronger and supportive. 9 ® Bridgewater Daily Observations 10/13/2011
  • 10. Expo rts as %GDP A US 3mo Gro wth 16% 12% Trade P artner 3mo Gro wth 10% 14% 8% 12% A bo ut a 1 o f GDP % 6% suppo rt a year fo r last few years 4% 10% 2% 8% 0% -2% Trade partner grow th 6% -4% has softened 4% -6% 00 02 04 06 08 10 90 92 94 96 98 00 02 04 06 08 10 12Inflation is Abating and Unlikely to Prevent RBA EasingCore inflation has been slowing alongside growth and is unlikely to be an obstacle for RBA easing. In itsOctober 4th monetary policy meeting, the RBA noted that it has “been weighing the question of whether aperiod of weaker than expected conditions would contain that pick-up in inflation. Recently revised datashow a pick-up to date in the underlying pace of price rises that was less sharp than initially indicated.Moreover, with labour market conditions now a little softer and households more concerned about thepossibility of unemployment rising, the likelihood of a significant acceleration in labour costs outside theresources and related sectors is lessening…Taking into account all the recent information, the path forinflation may now be more consistent with the 2–3 per cent target in 2012 and 2013.” We would expectthat a still-strong currency, combined with the clear deterioration in domestic conditions, should lead tosofter inflation going forward. CPI: Avg RBA "Core" excluding Deposit and Loans CPI: Melbourne Institute Core Measures YoY 7% 8% 7% 6% 6% 5% 5% Core inflation w ithin target band and falling 4% 4% 3% 3% 2% 2% 1% 1% 0% 90 92 94 96 98 00 02 04 06 08 10Monetary and Fiscal PolicyThough the RBA kept rates at 4.75% at the October 4th meeting, rates have been hiked 175bps in thecurrent tightening cycle and real rates are now roughly normal and the highest in the developed world ataround 2%. The recent deterioration of conditions has resulted in market expectations of 85bps of easingover the next 12 months, while just four months ago markets were pricing in nearly 20bps of tighteningover the ensuing 12-month period. The strong employment report did result in about 15bps less easingbeing priced in. 10 ® Bridgewater Daily Observations 10/13/2011
  • 11. RBA Cash Rate 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% The RBA has tightened 175bps thus far and the market is 3.0% currently pricing about 85bps of easing over the next 12mo 2.5% 00 02 04 06 08 10 12Of course, the level of rates in Australia is higher than in the rest of the developed world, and thus theRBA has room to ease rates. Employing a simple empirical model of the typical drivers of RBA policy, wesee that current market pricing is consistent with past RBA policy moves. The calculation below issimplistic and merely meant to capture basic normal cyclical conditions. We would expect that givenglobal financial problems and slowing, as well as the secularly high levels of debt in Australia, moreeasing than this is likely over the next year. AUS Typical Monetary Policy Change in Short Rate Estimate Based on Past CB Behavior 10% Market discounting a bit less than typical RBA monetary policy w ould suggest. Global and financial risks increase 5% odds of significant easing beyond current pricing. 0% -5% -10% -15% 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13In addition to monetary tightening, Australia has reduced the massive fiscal support provided during thecrisis, but the fiscal drag recently has been much smaller than in the rest of the developed world. Weexpect the impact of the new carbon tax to be small (and most of the actual tax increases are still manymonths ahead). Overall, we expect fiscal tightening to increase slightly in coming months but to have amodest impact on growth (about 30bps). The chart below shows our estimate of the impact of fiscalpolicy on Australian growth. For reference, Australia is running close to a balanced fiscal budget andgovernment debt levels are low, so it has the ability to provide fiscal stimulus should the need arise. 11 ® Bridgewater Daily Observations 10/13/2011
  • 12. 6% AUS Govt Impact on Growth, 6mo Trailing (%PGDP) 5% 4% Fiscal supports have been fading and should be a 3% small net drag on growth 2% (-0.3%) for the next 6 mo 1% 0% -1% -2% 08 09 10 11 12Australian growth has clearly deteriorated over the past six months and our latest readings point togrowth that remains below potential. Deteriorating conditions combined with high debt levels and fallingasset prices mean that the risks of a self-reinforcing deleveraging are rising. As commodity prices fall andtrading partner growth cools, external supports to growth are also likely to drop in coming months. In ourview, relative to Australian economic conditions and risks, the odds of a major easing cycle are greaterthan what is currently discounted.Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informationaland educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any ofthe recipients. Additionally, Bridgewaters actual investment positions may, and often will, vary from its conclusions discussedherein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, amongothers. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report isnot an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned.Bridgewater research utilizes data and information from public, private and internal sources. External sources include InternationalEnergy Agency, International Monetary Fund, National Bureau of Economic Research, Organization for Economic Co-operation andDevelopment, United Nations, US Department of Commerce, World Bureau of Metal Statistics as well as information companiessuch as BBA Libor Limited, Bloomberg Finance L.P., CEIC Data Company Ltd., Consensus Economics Inc., Consumer MetricsInstitute, Credit Market Analysis Ltd., Ecoanalitica, Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., GlobalTrade Information Services, Inc., Hewitt Associates, LLC, Intex Solutions, Inc., Markit Economics Limited, Mergent, Inc., Moody’sAnalytics, Inc., MSCI, RealtyTrac, Inc., RP Data Ltd., Standard and Poor’s, Thomson Reuters, TrimTabs Investment Research, Inc.and Wood Mackenzie Limited. While we consider information from external sources to be reliable, we do not assume responsibilityfor its accuracy.The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice.Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed.Those responsible for preparing this report receive compensation based upon various factors, including, among other things, thequality of their work and firm revenues. 12 ® Bridgewater Daily Observations 10/13/2011