In fact, the S&P500 volatility 1 on average was 2.58x that of the HFI s. Using over fifteen years of data, we found that S&P500 s volatility to be on average 2.5x that of the HFI s. II. ANALYSIS The Beryl Consulting Group LLC October 9, 2009 By: Rich Wenzel Abstract In this paper, we analyze hedge fund and equity index performance from 1994 until August 2009. We determine that the HFI volatility is significantly lower than equity index volatility. This is the second in a series of papers that analyzes the value of investing in hedge funds from return/risk and diversification benefits. Data & Return Calculations We used monthly return data to calculate two-year returns and volatility. The data starts from January 1994 and ends with August 2009 for one-hundredeighty-eight months of returns. Since we are using twenty-four months for each return and volatility calculation, we have one-hundred-sixty-five data points. The HFI has thirteen strategy sub indices. We have included some data on these indices and our abbreviations for our tables are as follows: Strategy Type Abbreviation I. INTRODUCTION Overview One of the basic tenets of finance is when investing the more risk taken, the more return required. This paper will look at the returns of the CS/Tremont Hedge Fund Index and compare them to the returns of the S&P500. This paper is a follow up to a previous paper that can be found here: http://home.berylconsulting.com/taxonomy/term/6 Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Event Driven Distressed Event Driven Multi-Strategy Event Driven Risk Arbitrage Fixed Income Arbitrage Global Macro CA DSB EM EMN ED EDD EDMS EDRA FIA GM In the previous paper, we concluded that from 2002 to mid 2009 hedge funds had outperformed three equity indices in terms of return/risk ratios. The return/risk differential stemmed primarily from significantly lower volatility. Long/Shorty Equity Managed Futures Multi-Strategy LSE MF MS 1 In this case volatility is defined as the standard deviation of twenty-four one month returns annualized by multiplying by the square root of twelve. BerylConsulting.com Page 1
Aug-96 Apr-97 Dec-97 Aug-98 Apr-99 Dec-99 Apr-01 Dec-01 Aug-02 Apr-03 Dec-03 Aug-04 Dec-05 Aug-06 Apr-07 Dec-07 Aug-08 Apr-09 Volatility Volatility Performance Review HFI volatility ever higher than the S&P 500 volatility. What we can see in Figure 1 is that HFI s highest observed twenty-four period volatility is lower than the average S&P500 volatility. In addition, all the individual strategies also had lower volatility than the S&P500 with the exception of the Dedicated Short Bias strategy. The average S&P500 volatility was almost exactly 2x that of the HFI s.. As seen in Figure 2, only in 1995 and 1996 was the Figure 1 Average 13.84% 6.87% 4.90% 16.88% 13.51% 4.11% 5.18% 5.65% Median 15.16% 7.97% 4.15% 15.78% 12.98% 2.13% 4.04% 4.79% Std Dev 4.85% 3.17% 3.04% 3.88% 6.16% 6.44% 2.53% 2.64% Max 23.07% 12.40% 16.47% 24.85% 26.32% 29.44% 10.72% 11.22% Min 6.43% 2.40% 1.31% 9.88% 5.85% 1.38% 2.58% 2.48% Average 5.69% 3.95% 3.89% 8.86% 9.03% 12.08% 4.11% Median 4.70% 3.74% 2.68% 9.27% 7.37% 11.96% 3.68% Std Dev 2.62% 1.48% 3.01% 5.22% 4.32% 1.59% 1.82% Max 11.57% 7.25% 13.93% 17.98% 19.12% 15.49% 10.28% Min 2.40% 2.18% 0.91% 2.80% 3.49% 7.29% 2.19% Figure 2 25% 20% S&P 500 and HFI Volatility 15% 10% 5% 0% S&P500 HFI BerylConsulting.com Page 2
Jul-96 Feb-97 Sep-97 Apr-98 Nov-98 Jun-99 Jan-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Nov-05 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 May-09 Basis Points Return Performance Review Figure 3 lists the two-year-return statistics. On average the HFI had a higher return than the S&P500, however it is not statistically significant. bubble. Post the bubble, the HFI fairly consistently had higher returns. In Figure 4, we see that the S&P500 had higher returns than the HFI mostly prior to the internet Figure 3 Average 17.29% 23.46% 17.88% -2.61% 21.37% 18.87% 23.92% 26.75% Median 19.85% 22.25% 17.46% -3.87% 27.48% 19.34% 24.67% 26.31% Std Dev 32.81% 15.93% 16.82% 15.96% 26.56% 16.01% 13.53% 16.28% Max 75.12% 65.14% 49.36% 44.86% 77.87% 38.68% 49.80% 61.48% Min -47.75% -11.39% -28.06% -43.65% -36.75% -38.74% -11.48% -18.29% Average 22.80% 15.89% 11.29% 32.50% 26.66% 14.32% 19.25% Median 24.03% 15.84% 12.99% 30.75% 27.17% 13.79% 20.79% Std Dev 13.29% 8.67% 12.18% 22.31% 20.52% 11.66% 11.13% Max 50.01% 38.26% 34.14% 95.80% 84.17% 51.50% 38.87% Min -7.17% -3.02% -26.09% -15.08% -13.36% -12.75% -16.00% Figure 4 6,000 4,000 S&P500 2 Year Return - HFI 2 Year Return 2,000 0-2,000-4,000-6,000 HFI - S&P500 BerylConsulting.com Page 3
Jul-96 Feb-97 Sep-97 Apr-98 Nov-98 Jun-99 Jan-00 Mar-01 Oct-01 May-02 Dec-02 Jul-03 Feb-04 Sep-04 Nov-05 Jun-06 Jan-07 Aug-07 Mar-08 Oct-08 May-09 X Return/Risk Performance Review 2 Return/risk type of metrics are extremely important, as they afford a view of the value of an investment. At Beryl we consider evaluating these statistics as an integral part of the investing decision. As shown in Figure 5, the HFI has an average return/risk ratio of 1.88 versus that of 0.79 for the S&P500. Post the internet bubble, the HFI has performed much better. Figure 5 Average 0.79 1.88 2.95-0.12 1.15 4.11 2.89 2.94 Median 1.00 2.08 1.93-0.10 1.08 4.17 3.10 2.69 Std Dev 1.20 1.13 3.38 0.50 1.24 1.77 2.00 2.10 Max 3.70 4.09 13.86 1.12 3.71 9.26 7.45 6.78 Min -1.45-0.66-1.14-1.68-0.91-0.75-0.75-1.30 Average 2.44 2.19 2.99 2.39 1.45 0.54 2.74 Median 2.31 2.17 2.03 2.26 1.77 0.57 2.66 Std Dev 1.72 1.38 3.37 1.58 1.03 0.42 1.54 Max 6.74 5.21 16.60 5.76 3.37 1.65 6.27 Min -0.42-0.41-1.12-0.54-0.87-0.90-0.91 Figure 6 5.000 Return/Risk Ratio 4.000 3.000 2.000 1.000 0.000-1.000-2.000 S&P500 HFI 2 Calculated as ((1 + 2-yr return) 1/2-1)/((monthly ) x 12 1/2 ) BerylConsulting.com Page 4
Volatility Comparison Probably the most important metric is a direct volatility comparison. We found in our previous paper that on average the S&P500 volatility was 2.58x the HFI s. This is very important because it says for the S&P500 to have the same return/risk performance as the HFI, the S&P500 has to have 2.58x the return. a moderately long period of time, for a long-term investor that hedge funds provide very good return/risk charateristics. In future research, we will show that hedge funds typically have low correlation with other asset classes and, thus, have good diversification benefits for portfolios. While there are some caveats to hedge fund investing, hedge funds provied excellent benefits for a sophisticated portfolio. Including data from 1994 to 1999 includes some of the equity markets best years and while it affected the statistics, we can still conclude that the HFI has much lower volatility. We also included a spread analysis; the S&P500 volatility minus the HFI volatility. On average, the S&P500 had almost 700 basis points more volatility than the HFI. As we can see in figure 7, the probability of the S&P500 volatility/hfi volatility or the HFI volatility minus the SP500 volatility is statstically signficant. Figure 7 Volatility Analysis S&P500/HFI HFI - S&P500 Average 2.50-6.97% Median 1.80-6.62% Std Dev 1.66 4.73% Std Error of Est. 0.13 0.00 t-stat 3 12.85 12.85 Prob Not 0 1.00 1.00 II. PARTING THOUGHTS As part of our series on the benefits of hedge fund investing, one of the first questions we wanted to answer was how do hedge funds perform as a stand alone asset class. Our research has shown that over 3 For these purposes, the t-stat is defined as the average divided by the standard error of the estimate. BerylConsulting.com Page 5