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The collapse of Peloton Partners' ABS Master fund renews interest in an old question: do hedge funds have any skill, or are their returns - insofar as they occur at all - merely a reward for taking particular risks? Two pieces of evidence suggest it's the latter.
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The first is the chart, below. It shows a close correlation (0.68, R-squared = 46.8 per cent) between hedge funds' 13-week returns, as measured by Hedge Fund Research's global hedge fund index, and changes in the US credit spread, the gap between the yield on Lehman Brothers high-yield corporate index and 10-year Treasuries. When the credit spread widens, hedge funds - on average - do badly. And when it narrows, they do well.
There are two reasons for this. One is simply that hedge funds borrow money, so tougher financial conditions, of which a higher credit spread is a symptom, hurt them. The other is that several hedge-fund strategies are in effect bets that companies won't go bust - they sell insurance against default. When default risk rises, it's more expensive to do this.
Our second piece of evidence is the table. It shows that just three things can explain four-fifths of the variation in hedge funds' quarterly returns - the pattern in the chart. These are:
| Explaining Hedge Fund returns | |||
| Coefficient | Standard error | Correlation | |
| Intercept | -0.074 | 0.093 | |
| TED spread | -2.698 | 0.301 | -0.26 |
| MSCI world index | 0.462 | 0.017 | 0.85 |
| Vix index | 0.169 | 0.028 | -0.44 |
| R-squared | 79.9 | ||
| Standard error | 1.1 | ||
| Based on 13-week changes since June 2003 | |||
| Dependent variable is HFR's global hedge fund index. | |||
1. The TED spread, the gap between three-month interbank rates and Treasury bill rates. When this rises, hedge funds lose, because their borrowing costs rise. Money gets tighter.
2. Global share prices. Hedge funds do well when these rise. This is partly because so-called 'equity market neutral' funds aren't neutral at all but rather carry market risk. It's also because a rising stock market is a sign of better times generally, which benefits hedge funds in several ways: reducing default risk, narrowing various financial spreads, and strengthening the dollar against lower-yielding currencies such as the yen, which some hedge funds borrow.
3. The Vix index. When volatility rises, hedge funds do well. This is only true, though, if we control for the TED spread and global share prices - the raw correlation between the Vix and hedge-funds' returns is strongly negative. The interpretation here is probably that it is moves in share prices that are uncorrelated with volatility that affect hedge funds' returns.
There's another important piece of information in our table - the intercept. This shows the return hedge funds get if we control for these three things. And it's negative, albeit statistically insignificantly so. Which suggests that hedge funds, on average, don't make money once we control for changes in financial conditions.
The message is simple. The average hedge fund is just a bet on good financial conditions: rising share prices and a narrower TED spread. They've lost money because these conditions have worsened - which is why there's been so much squealing about the credit crunch even though it's macroeconomic effects are hard to find. And they'll probably make money if they improve. There's no skill involved.
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-IC-1.9.0c-prod - 15/05/2009 11:00:33 - stuart.turner
