Market neutral hedge funds offer best risk/return figures – Mercer

Market neutral strategies tend to offer the best risk-adjusted returns of the main hedge fund categories, according to a report by Mercer Investment Consulting.

The report, written by Harry Liem in Mercer’s Sydney office, looked at various studies around the globe. It is now estimated that there are about 9,000 hedge funds with more than $US1.1 trillion under management. The report says equity market neutral managers tend to show low correlations of returns with external factors and also to their style index. Mercer found that equity market neutral funds had shown by far the lowest correlation with their style index of any strategy, followed by multi-strategy funds, convertible arbitrage and equity long/short. The higher correlation for equity long/short funds is because of systematic biases of net exposure to markets, growth stock biases and small-cap biases. Mercer says that what may be considered alpha would become beta in time as people became more aware of the biases. The lowest risk/return performances were found in emerging markets and managed futures funds, according to Mercer and a survey by Goldman Sachs. Testing performances at various points of market upheaval, such as the 1994 bond crisis and the 2000 share market ‘tech wreck’, Mercer found that most resilience was shown by equity market neutral and global macro funds. The report says: “Most equity-based hedge fund strategies have performed better under bullish than bearish conditions, and hence may not have delivered the desired diversification benefit. “Long/short equity managers have historically averaged a net market exposure of 50-60 per cent. This largely explains the tendency to perform better when markets are strong. Long/short equity managers have also tended to perform better when growth has outperformed value. This is normally associated with the later stage of a bull market when the demand for lower quality stocks increases, such as happened during the tech bubble of the late 1990s. “Similarly, M&A (event driven) managers need bullish market conditions to benefit from deal flow, as most activity tends to occur when equity prices are high, thereby reducing the cost of equity financing.” Mercer says that for hedge funds of funds (FoFs) the lower return dispersions shown recently are likely to persist. “When assessing fund of hedge funds, investors will need to examine the breadth of strategies employed, whether strong operational and investment due diligence teams exist and whether risk management is undertaken on a transparent basis,” the report says. “We already are seeing a number of managers develop single manager, single-strategy and multi-strategy products. This is to cater for the increased demand from clients to remove the second layer of fees, increase transparency and liquidity and implement the right mix of alpha and beta within their overall portfolios.”