Hennessee Group LLC, a consultant and adviser to direct investors in hedge funds, recently conducted a study examining the correlation between the breadth of equity market moves and the performance of long/short equity hedge funds relative to traditional indices. Through this study, the Hennessee Group confirmed that hedge funds generally lag their traditional counterparts when the equity markets experience strong advances and winners greatly outnumber losers as witnessed in 2009. Conversely, when the markets experience a more balanced move or a meaningful move to the downside, hedge funds generate significant alpha on a relative basis.
Hennessee Group research indicates that in market advances where winners outnumber losers by more than 3 to 1 (breadth ratio of 3.0), hedge funds generally struggle to differentiate themselves as performance is strongly driven by momentum (beta) as opposed to strong stock selection (alpha), says Gradante, managing principal of Hennessee Group. During such strong, broad based gains, hedge funds have a particularly difficult time identifying good shorting opportunities as there can be a disconnect between fundamentals and stock performance. Therefore, short positions generally serve as a drag on performance in these markets.
The Hennessee Group evaluated the performance of the Hennessee Long/Short Equity Index against the S&P 500 Index while also taking into consideration the breadth of the equity markets each calendar year period dating back to 1983. Over these twenty three calendar year periods, the Hennessee long/short equity index underperformed the S&P 500 Index ten times. During nine out of those ten calendar year periods, the Hennessee Group found that the S&P 500 Index experienced at least 3 times the number of winners than losers (the lone exception we observed was 1998 when Long-Term Capital Management meltdown which caused distress in the hedge fund industry). To illustrate, in 2009, 425 of the S&P 500 Index constituents experienced gains while 73 experienced losses. With over five stocks up for every one stock down for the year, hedge fund managers found it very difficult to successfully add value with strong selection, particularly on the short side. The most profitable portfolio strategy in such an environment was to increase net exposure and lever the portfolio to benefit from the beta driven market. That said, while hedge funds generally lagged in such beta driven environments, they still managed to perform well as the Hennessee Long/Short Equity Index generated positive returns each calendar year, with double digit gains in eight of the ten.
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