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 July 2007 You Can Beat the Index Hedge Strategies Don't Require Hedge Funds
But somewhere along the way, many hedge fund managers have taken the “hedging” out of their funds. Rather than trying to offset risk, they’ve used leverage to embrace more. This has rewarded them over the past five years as equity markets – particularly the U.S. market – have posted almost uninterrupted gains. This, of course, comes with the price of increased risk. It’s that old alpha and beta thing again, but in many instances the stakes are somewhat higher. Put simply, beta is the risk of the market. A security’s beta is measured relative to that of the benchmark such as the S&P 500, so a beta of 2 would indicate the security has twice the market risk of the index. With a direct relation between risk and return, one might expect it to also have twice the return of the benchmark. Some investments are inherently more risky than the market. You can find a lot of them in the small cap arena, emerging market stocks, or even in the large cap tech sector. You can accomplish the same thing by using leverage to increase your exposure to index-tracking mutual funds or exchange traded funds (ETFs). In either case, your additional return stems from your heightened market risk, not because you’ve somehow added value over and above the return of the benchmark index. That latter concept is where alpha comes in. Many managers advertise their ability to “add alpha” through their shrewd stock-picking, asset allocation, or investment approach. They’re claiming to increase your return while keeping risk levels close to that of the index. Today’s hedge funds tend to generate their returns by relying on beta. That’s not to say they’re all high-risk enterprises, but simply that much of their trading is built around managing beta – often at much higher levels than that of a benchmark index. Many that claim to “add alpha” generally fail, and when they do beat their benchmarks, it’s often more attributable to beta than alpha. When that happens, risk control is often a casualty.
But it wasn’t always this way. Hedge funds used to strive for alpha as well as their eponymous risk control. Many succeeded, but not anymore. This is a consequence of their new-found popularity. As interest in hedge funds has grown, so have investors’ demands for higher and higher returns. It’s much easier to manipulate a portfolio’s beta than actually create alpha. As a result, that’s what hedge fund managers are doing, just to remain competitive in their field. Even in the good old days when hedge funds were actually adding alpha, they did so in an incremental fashion. Investors expected no more than 1-2% over the benchmark. They were happy with this result if for no other reason than because it was achieved without an undue increase in overall risk. Here in the midst of the 5-year bull market, most investors don’t feel this way anymore. If anything, they’re encouraging their managers to take on more risk in an effort to boost return. Certainly that will change when the market again proves it’s cyclical, but probably no sooner. On the other hand, if you’d be happy to annually beat a benchmark like the S&P 500 on an incremental basis, you don’t have to wait for everyone else to come around. In fact, you don’t need a hedge fund to do it – you can efficiently do it yourself.
Beta + Alpha
To be sure, the rub lies in the alpha component. With today’s index mutual funds and ETFs, you can easily track an index with essentially the identical risk. The question is: How can you consistently add alpha without straying from the benchmark’s risk and return? If you use an index mutual fund or ETF, 100 cents of every dollar you invest has to be tied up in the index fund just to achieve the required beta, there’s nothing left over for alpha. Hedge funds have a way around this by using futures and options to replicate the index return without actually investing in it. Futures and options are purchased at cents on the dollar, leaving the difference available to generate alpha. A typical approach would involve buying sufficient S&P 500 futures to mirror investment of the entire fund, and then investing the difference in Treasury Bills with the same maturity. The futures would deliver the market return at the market beta, while the T-Bills – generally viewed as the riskless asset – would provide the alpha. The degree of alpha is dependent on the T-Bill yield and the amount of the fund invested in them. For example, if T-Bills have a 4% annual yield and 30% of the fund is left after purchasing the necessary S&P 500 futures, expected return would be that of the index plus 1.2% (30% x 4%). Unless the S&P was up significantly, this would fall well short of the returns claimed by many of today’s go-go hedge funds. But for an investor seeking a consistent index-beating return, this strategy can yield some stellar long-term results.
1999 or 2007? Both will have higher fees than plain vanilla alternatives, but this is to be expected given the greater degree of management skill required to run a leveraged fund. As with all ETFs, leveraged ones can be bought or sold at any time during the day but do carry a commission for each transaction. Most leveraged mutual funds are considered trading vehicles so don’t carry a front-end load or surrender charge. Nevertheless, these factors are worth checking out before making any purchases. You don’t have to buy T-Bills to make this strategy work, either. Instead, you can pair your leveraged fund with a “market neutral” mutual fund. Managers of these funds attempt to zero out the fund’s beta by buying and shorting stocks. In essence, the beta of the stocks they purchase (the long positions) equals that of the stocks they sell (the short positions), offsetting one another and leaving the overall fund with a beta of zero. Any gains they make from either position provide your alpha. Consider how this would work with combination of two mutual funds. There are a lot of funds you can use for this purpose, but in general you’d want them to have the following features. First, look for a leveraged index fund with 2x exposure to the benchmark. If only 50 cents of each dollar is invested in it, you should receive the full return of the index.
Next, consider a market neutral fund for the other 50 cents. You’ll get half of whatever its annual net return is for your alpha. When the funds are combined, you should enjoy the return of the market plus your alpha. The risk (beta) should be roughly equal to that of the market – possibly even less if your market neutral fund has a slightly negative beta.
Limitations and Variations The strategy will usually beat the index, but just not to the degree theory would predict. You can increase your odds by finding and sticking with the best managed alternatives. The main problem is that funds rarely if ever perform as expected. This isn’t because of poor management or deceptive advertising, but rather the result of expenses and rapidly changing market conditions. Both can negatively impact leveraged funds as well as market neutral funds. Managing a leveraged mutual fund is harder than you might at first imagine. Any strategy that depends on derivatives and predictions of future market movements is prone to adverse swings when the market doesn’t cooperate. Although it’s possible to quickly compensate for unexpected short-term market events, the negative effects compound over time, diminishing expected performance. As a result, even the top-rated leveraged equity funds fail to consistently perform to the magnitude projected by their leverage. In other words, a fund with 2x leverage rarely ends the year with more than twice the return of the benchmark. This shortfall cuts into whatever alpha your market neutral fund generates. Which brings up another consideration: Just because a fund has both long and short positions, it’s not necessarily a market neutral fund. In fact, it probably isn’t. As of April 30, 2007, Morningstar lists 14 distinct long/short funds with a five-year history, and there's only 4 market neutrals among them. This is understandable given that true market neutral funds usually offer returns right around our slightly above that of the 1-year Treasury Bill. For equity investors, that's not particularly special. Managers of long/short funds don’t try to zero out beta so are free to tilt the portfolio in whichever direction they believe will create the greatest return. This makes them resemble a more aggressive hedge fund with return coming not only from alpha, but from elevated beta bets as well. In rising markets, you can boost your potential return by using a long/short fund instead of a market neutral, but realize this isn’t simply adding alpha to the index return, you’re adding risk as well. In a down market, a true market neutral fund will hold up much better than a higher-beta long-short fund. If you really want to lock in the “alpha” component of the strategy, you could always use a straight-forward CD. When prevailing interest rates are high, a plain vanilla CD will outperform long/short funds as well as market neutral funds – and the return is FDIC insured. If you’re more adventuresome, you might go with a long/short fund in up markets and a market neutral fund when the bear comes around. This, of course, adds additional market-timing risk and possibly transaction costs as well, so you need to be fairly confident about the market’s direction before making the switch. Along the same lines, you might want to consider dumping the leveraged index fund when the market enters a prolonged decline. Remember, if it’s designed to move up at twice the pace of the benchmark, it will move down at twice the pace, too. In a true bear market, you’d be better off holding cash and a market neutral fund. Finally, if you’re willing to abandon the simple beta plus alpha approach, you can turn this into an absolute return strategy by switching to an “inverse” fund during market downturns. Most fund companies that offer leveraged index funds also offer funds that seek to provide the inverse return of the index; in other words go up by the same amount the index goes down, and vice-versa. When the market’s in a steady decline, inverse funds will (should) be in a steady climb. Obviously this adds another layer of market timing and transaction expense, not to mention risk. The fancier you get, the more your strategy resembles today’s aggressive hedge funds. With so many leveraged and long/short products now available, you can be as aggressive or conservative as you want. Even with the most conservative approach – a leveraged index fund coupled with a market neutral fund or CD – you should be able to “beat the index” – even without a hedge fund. Search this site! Just enter you key word or words:
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EDGE FUNDS USED TO actually hedge risk. With the ability to short stocks or use leverage in a controlled manner, managers not only could offset the market risk that haunts traditional long-only portfolios, but could provide market beating returns as well. It’s those returns that have led to hedge funds' new-found popularity.
