Bridgewater Associates: Hedge Funds Selling Beta As Alpha - May 2005

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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 can be duplicated or redistributed without prior consent from Bridgewater Associates. Copying or redistribution of The Bridgewater ® Daily Observations is in violation of the U.S. Federal copyright law (T 17,U.S. code). 1 Bridgewater ® Daily Observations 05/24/2005 Bridgewater® Daily Observations May 24, 2005 © 2005 Bridgewater Associates, Inc. (203) 226-3030 Greg Jensen Noah Yechiely Jason Rotenberg Hedge Funds Selling Beta as Alpha (An Update) Revised 3/10/2006 While exact numbers are hard to come by, the best estimates indicate that the total inflows into hedge funds in 2004 probably topped $120 billion. The three strategies benefiting most in 2004 were Equity Long/Short, Event Driven, and Macro, with 27%, 18%, and 15% of the total flow respectively. This inflow into hedge funds has grown each year and the trend is likely to continue. The space remains largely dominated by wealthy individuals who make up about 50% of hedge funds investors, but this is quickly changing. Endowments have been pouring into hedge funds, and the huge pension fund investors are beginning to test the waters. In general, we view the move into hedge funds as a positive development for investors. As we have described in the past, the investment world should, and will, evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked. Instead, investors should decide which asset classes they want to be in and then overlay on top of these asset classes the best alpha managers they can find, no matter which asset class they get their alpha from. This is alpha overlay, and it is a better way to run a portfolio. Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy. To the extent that investors are able to use hedge funds to get access to more and better alpha sources to overlay on their portfolio, the dive into hedge funds is worth taking. Too often, however, hedge funds are mixing alpha and beta together, blurring the picture. To be clear there are only two ways to make money in market, and it is essential to be able to differentiate between the two. Beta - One way to make money in financial markets is to take on a systematic risk for which the market compensates you. This type of risk is known as beta. For instance, asset classes like equities have a higher expected return than cash over time for the simple reason that they are a more risky investment than cash. The same is true for long duration bonds versus cash, corporate bonds versus treasuries, mortgages versus treasuries, emerging market debt versus developed market debt, etc. At any given point in time, risky financial assets may be expensive or cheap, but over time, they should return more than less risky assets. Betas are easy to capture (i.e. naïve investment strategies can capture betas). Over significant periods of time, betas have positive returns. However, they have low ratios (we estimate that over long time-frames betas have annual Sharpe ratios ranging from 0.2 to 0.3), and for the most part, they are correlated to one another (in part because risk itself is inherent in each of them).
  • 2. Alpha - The other way to make money in financial markets is by taking it away from other market participants. This is known as alpha. Alpha is zero-sum. For every buyer, there is a seller, and so for every alpha trade, there is both a winner and a loser. Examples of alpha strategies include market-timing and active security selection. Only investors who are smarter than the market will be able to reliably provide alpha. Finding managers who can consistently beat other financial market participants is certainly a daunting challenge, but in our view, it is necessary and unavoidable. The skill is rare, and therefore, the price of alpha is reasonably high. This being the case, a savvy investor should be unwilling to pay significant fees to an asset manager who is essentially taking in risk premiums for them. Taking in risk premiums over the long run is too simple to replicate, and it provides a lousy long-term ratio of risk to return (while often providing great ratios in the short run). Since hedge funds often mix the two and charge investors for both, the waters can become a bit murky. The general perception right now is that hedge funds are providing alpha. In truth, many hedge funds are packaging up beta and selling it at alpha prices. When we strip many hedge fund “strategies” from the beta that underlies them, we find that quite often, they are not wearing any clothes at all. For instance, the recent experience with convertible arb players is illustrative. Convertible arb has been a popular hedge fund strategy for years, but the strategy has a large beta component to it. Convertible arbitrage funds take convertible bonds and hedge out some of the underlying pieces. A convertible bond has three components (credit, volatility, and equity). Most convertible arb players are going to do well, when convertible bonds are sold at a discount to the underlying pieces and poorly when the convertible sells at a premium. That is why most convertible arb funds are so highly correlated. For much of the last decade there has been more supply of converts than demand, which has allowed converts to trade at a discount. This led to solid returns for entities able to hedge out the pieces (i.e. convertible arb hedge funds). Forty billion dollars flowed into these funds and naturally the discounts closed, performance moderated and money started getting pulled out. This is forcing funds to liquidate their positions. The following chart illustrates the accumulated returns of convertible arb funds with the flows in and out. For the first time, money is being pulled out of these funds and they are down nearly 6% ytd. -1 -0.5 0 0.5 1 1.5 94 95 96 97 98 99 00 01 02 03 04 05 -0.8 -0.3 0.2 0.7 1.2 Asset Flow into Convertible Arbitrage Hedge Funds (Bn USD) Convertible Arbitrage Hedge Fund Index - Cumulative Return (ln) The following chart illustrates the beta in convertible funds. The chart below illustrates the 50% correlation (increasing to 70% in the last 3 years) between Convertible Arb fund returns and a naive replication. The replication consists of a long position in a basket of newly issued convertibles (up to 6 months old) and 0.3 delta hedge with the respective equities. 2 Bridgewater ® Daily Observations 05/24/2005
  • 3. -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Convertible Arb Strategy Replication using New Issues 0.3 Delta Hedged (Exc. Cash)-Rolling 6mo Convertible Arb Hedge Funds Returns (Excess Cash, Net of Fees)-Rolling 6mo Correlation: 50% In many cases (not just convertible arb), hedge fund betas are not hard to strip out. One of the most popular hedge fund strategies has been fixed income arbitrage. This is a classic beta strategy. We don’t claim to be experts at what all of these guys are doing, but in aggregate, the picture is pretty clear. Simplistically, these funds are taking three systematic risks. The primary systematic risk is buying illiquid, risky securities (e.g. MBS, EMD) and shorting more liquid, less risky securities. The second strategy is positive carry trades, e.g., long-term US treasuries vs. cash. The third strategy is selling volatility. Some funds probably can sort the good securities from the bad ones, but in aggregate, fixed income arb funds have simply returned the beta of buying illiquid fixed income instruments. In aggregate they are 78% correlated to the naïve strategy of being long a simple combo of mortgages, emerging market debt, euro dollars relative to treasuries, long- vs. short-term treasuries, long high yielding currencies, and short volatility. One difference between the strategy of an average fixed income arb hedge fund and the naïve strategy is that the naïve strategy would have had slightly higher returns (in 2004 the naïve beta combo returned 9.1%, while the hedge funds returned 7.0%). The following chart plots the rolling six-month returns of a naïve mix of illiquid fixed income instruments against the rolling returns of fixed income arb hedge fund players. Our replication suggests that these strategies are getting squeezed in May, but the hedge funds have not reported yet. -15% -10% -5% 0% 5% 10% Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Fix Inc. Arb Replication using MBS, EMD, Euro$&Treasury Spreads and Volatility (Exc. Cash)-Rolling 6mo Fix Inc. Arb Hedge Fund Returns (Excess Cash, Net of Fees) - Rolling 6mo Correlation: 78% Similarly, emerging market hedge funds are over 80% correlated to a simple 50/50 mix of emerging market equities and bonds and are failing to outperform this basic combo. 3 Bridgewater ® Daily Observations 05/24/2005
  • 4. -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 EM Strategy Replication using EM Equities & EMD Returns (Exc. Cash)-Rolling 6mo EM Hedge Funds Returns (Excess Cash, Net of Fees)-Rolling 6mo Correlation: 80% Distressed securities hedge funds match up well to a basic mix of junk bonds and high-yielding emerging market debt. -30% -25% -20% -15% -10% -5% 0% 5% 10% 15% 20% Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Distressed Securities Strategy Replication using High Yield Returns (Exc. Cash)-Rolling 6mo Distressed Securities Hedge Funds Returns (Excess Cash, Net of Fees)-Rolling 6mo Correlation: 78% M&A arb funds, another popular hedge fund strategy, do no better than simply buying the top 10 announced targets and selling the top 10 acquirers. The following chart illustrates the 52% correlation of M&A arb players to this simple mix. -10% -5% 0% 5% 10% 15% Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Risk Arb Strategy Replication Long Acquisitions Short Acquirers (Exc. Cash)-Rolling 6mo Risk Arb Hedge Funds Returns (Excess Cash, Net of Fees)-Rolling 6mo Correlation : 52% 4 Bridgewater ® Daily Observations 05/24/2005
  • 5. Managed-futures hedge funds are a different type of animal, yet it is not too difficult to lift up the curtain in this case either. Managed-futures funds virtually all ride on technical traders. They tend to have very “complicated processes” that buy when a market has been going up and sell when a market has been going down. They don’t collect beta in a simple sense, but their alpha strategies are all so similar that it looks like beta. We can replicate, with a 70% correlation, the typical managed-futures hedge fund with a basic trend following/moving average strategy applied to the major futures markets. -20% -15% -10% -5% 0% 5% 10% 15% 20% 25% 30% Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Managed Futures Strategy Replication using Trend Follow ing of Eq./FX/Comm./Agri. (Exc. Cash)-Rolling 6mo Managed Futures Hedge Funds Returns (Excess Cash, Net of Fees)-Rolling 6mo Correlation: 70% The basic point here is that many hedge funds have a lot of beta (systematic risk) embedded in their strategies and returns. Investors investing into hedge funds need to consider the implications of these systematic risks in the hedge funds they are invested in. These beta sources are easy to access (at least for major institutions) if they choose to. Institutions should not, and likely will not, pay hedge fund fees to access beta. We are surely biased, but if we were looking for hedge funds, we would be looking for at least a few things: 1) Long Track Record - excellent performance through many economic environments (only 9% of hedge funds have more than 10 years of history) 2) Low Beta Content - low correlation to other asset classes and hedge fund styles 3) Transparency 4) Reasonable Leverage Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, Inc. 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. 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 is based primarily upon proprietary analysis of current public information from sources that Bridgewater considers reliable, but it do not assume responsibility for the accuracy of the data. The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. The views represent Bridgewater's outright views in these specific markets, but not all markets that Bridgewater trades. 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. 5 Bridgewater ® Daily Observations 05/24/2005