Bridgewater Associates: Hedge Fund Returns Dominated By Beta - May 2012

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Bridgewater Associates: Collection of Writings (1999-2012)

Bridgewater Associates: Collection of Writings (1999-2012)

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  • 1. 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 05/03/12 Bridgewater® Daily Observations May 3, 2012 ©2012 Bridgewater Associates, LP (203) 226-3030 Bob Prince Noah Yechiely Jason Rotenberg Justin Ash Hedge Fund Returns Dominated by Beta After a rough year in 2011, hedge funds as a group are off to a good start in 2012, with the average fund gaining 4% in the first quarter, after a 2.6% loss last year. This, again, seems largely due to an underlying long bias with respect to risk premiums, equities and other assets that are biased to perform well when economic growth surprises on the upside. The substantial presence of beta has diminished hedge funds’ value as an absolute return vehicle and increased the volatility of their returns. And since most institutional investors have a concentration in equities and equity-like assets, hedge fund returns have tended to be highly correlated to the returns on those assets, reducing their diversification benefit to institutional investors. When you extract the underlying "beta" from hedge funds' total returns, it looks to us like the aggregate industry alpha is roughly zero so far this year and is still down a shade since 2008. In recent years, higher than normal correlations among equity sectors and individual stocks and corporate spreads have reduced alpha opportunities for equity managers, and choppy markets have hurt the trend-followers. Of course, these observations apply most reliably to the aggregate returns across a portfolio of hedge funds and will apply in varying degrees to individual managers. As we have described in previous Observations, we replicate the beta embedded in the returns of various hedge fund styles in order to understand them better. Aggregating these beta replications across all the manager styles to the total hedge fund universe, the beta replication is 94% correlated to the aggregate index return. Last year’s losses and this year’s favorable results so far can be attributed to the underlying betas in the manager returns, as shown below. Hedge Funds 6mo Rolling Actual Return vs. Replication -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 CSFB HF Index Replication Correlation: 0.94
  • 2. 2 Bridgewater ® Daily Observations 05/03/12 By isolating and subtracting this beta component from managers’ returns we can estimate their "true alpha". The following chart shows the total return of the above hedge fund index (the red line) and the true alpha (the blue line), which is what remains after the beta replication is subtracted from the total return. As shown below, the aggregate hedge fund alpha has been roughly flat for a number of years and the volatility of returns has been dominated by the beta component. The table below shows the breakdown by year of the hedge fund returns shown above into their alpha and beta components. The beta component of those returns is about three times as volatile as the alpha component. And since 1994, 77% of the cumulative return has come from beta and 23% has come from alpha. The alpha component of the returns has been roughly flat since 2008. -20% 0% 20% 40% 60% 80% 100% 120% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Hedge Funds Cumulative Alpha Return Hedge Fund Cumulative Excess Returns (ln) Net Excess Hedge Funds Returns Beta Alpha 1994 -8.4% -13.9% 5.5% 1995 15.5% 22.5% -7.0% 1996 16.4% 13.0% 3.4% 1997 19.9% 14.4% 5.5% 1998 -5.0% -8.5% 3.5% 1999 18.0% 10.4% 7.6% 2000 -0.9% 0.3% -1.2% 2001 1.1% 1.9% -0.8% 2002 1.4% -3.9% 5.3% 2003 14.3% 14.7% -0.4% 2004 8.1% 8.1% 0.0% 2005 4.2% 5.0% -0.8% 2006 8.6% 6.2% 2.4% 2007 7.8% 2.8% 5.0% 2008 -20.1% -20.0% -0.1% 2009 18.4% 22.2% -3.8% 2010 10.8% 7.9% 2.9% 2011 -2.6% -1.0% -1.6% 2012YTD 4.0% 3.9% 0.1% Stdev. of Returns 10.5% 11.1% 3.7% Cumulative Return (ln) 112% 86% 26% % of Total 100% 77% 23%
  • 3. 3 Bridgewater ® Daily Observations 05/03/12 Not Much Diversification Benefit from Hedge Fund Returns As the beta component of managers’ returns tends to be the dominant piece, particularly for hedge funds as a group, and since this piece is highly correlated to equities and other rising growth assets, it tends to be highly correlated to the underlying asset allocation of the vast majority of pension funds. The alpha component is uncorrelated to both, but has been much less significant. As shown below, the beta component of hedge fund returns has been 75% correlated to a 60/40 portfolio. Correlations of Hedge Funds’ Beta, Alpha, and 60/40 Portfolio, 1994-2012 The aggregate return of hedge fund managers is highly correlated to a typical 60/40 pension portfolio because both have a heavy exposure to equities and the equity-like returns embedded in credit spreads. The following chart shows our estimate of the current exposure weights, which flow into the replication returns shown above. According to our estimates, the aggregate hedge fund index is the equivalent of holding 55% of your risk in equities, another 39% in various credit spreads and about 6% in treasury bonds. Hedge Fund Betas Risk Exposure: March 2012 As we have discussed in our research, which views asset returns through an “All Weather” lens, three forces account for the lion’s share of any asset class return: discounted growth, discounted inflation and the future value of cash (which is the sum of the discounted return of cash plus a required risk premium above cash). Each of the asset classes that comprise the replication of hedge fund betas has a certain beta to these three forces. Aggregating these betas to the total portfolio, we can see to Alpha Beta 60/40 Portfolio Total HF Portfolio 0.12 0.91 0.68 Alpha -0.30 -0.24 Beta 0.75 0% 10% 20% 30% 40% 50% 60% 70% Equities EMD Spreads Corporate Spreads MBS Spreads Nominal Gov. Bonds
  • 4. 4 Bridgewater ® Daily Observations 05/03/12 what extent these three forces drive aggregate hedge fund returns, and the attribution of this return to the three forces. As shown below, hedge funds’ unbalanced exposure to these three forces is about 80% correlated to their returns. And most of this exposure comes from a favorable bias to discounted growth and risk premiums. Hedge funds seem to have very little exposure to discounted inflation. The following charts show the attribution of these three forces to the aggregate hedge fund index return (i.e., the sum of the three equals the likely return of the hedge fund index). Hedge Funds 6mo Return Split into Discounted Growth, Inflation, and Risk Premiums -30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 Hedge Funds Actual Rolling 6m return Hedge Funds AW Lens replication Rolling 6m return Growth -20% -15% -10% -5% 0% 5% 10% 15% 95 97 99 01 03 05 07 09 11 Large exposure to changes in discounted growth... Risk Premium -20% -15% -10% -5% 0% 5% 10% 15% 95 97 99 01 03 05 07 09 11 …and risk premiums... Inflation -20% -15% -10% -5% 0% 5% 10% 15% 95 97 99 01 03 05 07 09 11 …amuchlower exposureto changes indiscountedinflation
  • 5. 5 Bridgewater ® Daily Observations 05/03/12 Post-Crisis, Hedge Funds Have Not Generated Alpha With respect to alpha, hedge funds primarily generate alpha from security selection, market timing (changes in their net long position) and trend following. The environment in the past five years has been challenging for these typical sources of alpha as the forces driving markets have produced correlated and choppy markets. For example, the chart below shows the rising correlation of equity sectors, which increased from an average of about 65% in prior years to 85% in the past five years, making it more difficult to generate alpha by diffing equity sectors. And historically, hedge funds’ ability to time the stock market (proxied by changes in net leverage of equity long/short funds) has been mediocre over the long term and flat over the past five years. 20% 30% 40% 50% 60% 70% 80% 90% 100% 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Average Correlation Across Equity Sectors Long-term average correlation has been about 65% Average correlation across sectors increased to 85% -3% -2% -1% 0% 1% 2% 3% 4% 5% 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Hedge Funds Market Timing Cumulative Return Flat performance
  • 6. 6 Bridgewater ® Daily Observations 05/03/12 Across currencies, bonds, stocks and commodities, markets have also been choppy rather than trending since 2009, leading to a roughly flat performance of naive trend-following approaches. This contrasts with 2008, when big moves produced great performance for trend-followers and pulled a lot of money into trend-following CTAs. In recent years, the volatility and low return of equities has been a drag on the beta component of hedge fund returns. And the combination of both choppy and correlated markets and bad market timing has produced roughly flat alpha since 2008. This combination has led to roughly flat industry returns since 2008, with the ups and downs driven almost entirely by swings in actual and discounted economic growth and risk premiums. -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Trend Follow ing Cumulative Return Flat performance Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This report is not 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 International Energy Agency, International Monetary Fund, National Bureau of Economic Research, Organisation for Economic Co-operation and Development, United Nations, US Department of Commerce, World Bureau of Metal Statistics as well as information companies such as BBA Libor Limited, Bloomberg Finance L.P., CEIC Data Company Ltd., Consensus Economics Inc., Credit Market Analysis Ltd., Ecoanalitica, Emerging Portfolio Fund Research, Inc., Global Financial Data, Inc., Global Trade Information Services, Inc., Markit Economics Limited, Mergent, Inc., Moody’s Analytics, Inc., MSCI, RealtyTrac, Inc., RP Data Ltd., SNL Financial LC, 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 responsibility for 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, the quality of their work and firm revenues.