Broadly construed, statistical models effectively can break down the return stream of a given hedge fund portfolio into a set of weighted exposures to certain market factors (e.g., the S&P 500, Treasurys, etc.). This approach has clearly demonstrated that hedge funds, as a group, generate the majority of their returns through shifts in asset allocation among major markets. Even during the “high alpha” pre-crisis period, the vast majority of returns came from increases and decreases in broad market exposures. Looked at this way, the hedge fund industry is a powerful guide to asset allocation decisions over time.
This consistency of exposures contradicts the belief that security selection drives the majority of returns – while true for individual managers and possible for highly concentrated portfolios, this isn’t the case for diversified portfolios. What this means, then, is that the information we derive from these models is valuable and useful: it provides a window into where hedge funds see better returns going forward. In one striking example, we saw a major shift in the portfolio in early 2011 away from emerging markets and into US equities. In retrospect, it’s quite clear today that this accurately reflected a reassessment of the relative attractiveness of US equities versus those in developing markets. The chart below displays the respective weights in the portfolio for emerging markets versus domestic equities:
In practice, as we spend a great deal of time looking at historical returns in order to determine what precisely drove returns, we learn a great deal about the characteristics of the strategy or portfolio. We know that certain strategies retain more consistently stable market exposures over time. We can study whether a hedge fund allocator shifts exposures aggressively or not.
The common concern is that statistical analysis is “backward looking” and therefore is only marginally relevant to understanding hedge fund whose managers are “forward looking.”
First, the empirical results over the past five years strongly support the position that hedge funds shift exposures slowly enough (they do change, but over months and quarters) that good statistical models do in fact detect the shifts on a timely basis – even though they are “backward looking.” Some strategies are particularly stable: equity long-short, event-driven and credit managers, to name a few. Managers that do shift exposures rapidly – such as CTAs – are much more unpredictable, but usually constitute a minority of industry exposure.
Second, for the majority of hedge fund strategies, it “makes sense.” Equity long-short, event-driven and credit managers generally build up positions over months and quarters based on incremental research and market information. Consequently, today’s portfolio reflects a cumulative series of decisions over the past year or more. Whether they make or lose money this month will largely be the result of accumulated decisions over the preceding quarters. Therefore, the positions today are, in fact, “forward-looking” in that they reflect the collective views of the underlying managers of where returns will be. The importance of recent returns—and their distillation into market exposures—remain important windows into prospective opportunities in the industry going forward.