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Stock indexes have outperformed hedge funds by quite a bit this year. As of late May, the NASDAQ is up 30%, the S&P 500 is up 10%, and the hedge fund industry is roughly flat. With such divergent performance might hedge funds have lost their edge, or is something else going on?
Over the last 20+ years hedge fund strategies have generated cumulative returns a bit better than stocks with considerably less volatility, an outcome resulting from a combination of two very different dynamics. During periods of near zero rate policy, stocks perform better than hedge funds (though hedge fund risk/return remained superior). In periods where interest rates were modestly above zero, hedge funds performed considerably better. In short, consistent outperformance of stocks relative to hedge funds required sustained easy money – that’s an era unlikely to soon return.
The chart below puts that into context by showing the difference between the rolling 6 month returns of stocks (measured by the SPY ETF) and hedge funds. It's apparent that in periods of easy money, stocks generally did better and vice versa. The recent outperformance of stocks during a period of relatively tight money is pretty unusual.
Source: Credit Suisse, Bloomberg, HFR, Barclaryhedge, Yahoo Finance, FRED and Unlimited Calculation. The results depicted are aggregated results and do not represent returns that an investor attained. Past performance not indicative of future results.
The picture is clearer if we simply break the last 20+ years into two periods – one with easy money and the other without. During the periods of near zero rate policy (defined as below 1%), stocks outperformed hedge fund returns. During periods of above 1% rates, the opposite was the case. What is particularly striking is the significant difference in the Sharpe Ratios of the two asset classes during the two periods. While hedge funds risk/return remained relatively stable during the different economic environments, the Sharpe Ratio for stocks was multiples higher during near zero rate policy.
Source: Credit Suisse, Bloomberg, HFR, Barclaryhedge, Yahoo Finance, FRED and Unlimited Calculation.The results depicted are aggregated results and do not represent returns that an investor attained. Past performance not indicative of future results.
Note the above is showing average monthly returns rather than cumulative returns. Because of volatility drag, the cumulative return of the Hedge Fund Index, Gross was 30bps per year higher than SPY over the time period shown.
There are fundamental reasons why stocks should do better than hedge funds in a period of near zero interest rate policy. While alpha (beating markets) isn't obviously sensitive to rates since returns are generated from timing skill, equity prices clearly benefit from falling rates and monetary stimulation:
- The most direct way is through the decline in the discount rate which elevates all asset prices including equities.
- Further, monetary stimulation during these periods is explicitly directed at using elevated asset prices to increase demand.
- Macroeconomic dynamics also benefit during times of very low rates because the needed return on capital of any project is low, which means industry leaders can invest in any project vs. being selective. Further, low rates allow industry leaders to finance acquisitions cheaply to consolidate emerging competitors. That particularly favors existing leaders in equity market indexes. An interesting paper discussing this dynamic can be found here (h/t Diane Swonk).
The chart and tables above are based on the S&P 500, but the dynamic can be seen even more extremely in the NASDAQ, which has even more duration sensitivity and industry concentration (in the FAANGs). Over the last 25 years, short term rates were over and under 1.5% about half the time each. The majority of the NASDAQ return came during periods of rates below 1.5%.
Source: Yahoo Finance, FRED and Unlimited calculations.The results depicted do not represent returns that an investor attained. Past performance not indicative of future results.
From a Sharpe Ratio perspective, the divergence is exaggerated because the weaker performance comes when rates are at higher levels. Seems investors taking on NASDAQ risk during periods of elevated rates are taking high volatility for not much advantage vs. cash.
Source: Yahoo Finance, FRED and Unlimited calculations.The results do not represent returns that an investor attained. Past performance not indicative of future results.
While rates today remain well above zero, it’s likely that we are seeing how expectations of much lower rates are supportive to asset prices early in 2023. Many are predicting a swift return to lower rates as growth cools and inflation moderates back to the 2% level they have been accustomed to over decades. For a period early this year, this was driven by an expectation of a pivot first from falling inflation and then caused by the banking crisis. The story shifted again in May driving equities to new highs because of expectations that AI could bring disinflationary pressures into the economy, which would benefit companies and also allow for easier monetary policy.
It's normal for investors to extrapolate their recent experiences into their predictions, but the current environment is very different from most of the post-GFC period. For the first time in decades, inflation seems stable at elevated levels and may be showing signs of being entrenched. While low rates were a boon to stocks, the opposite dynamics are also true – in the current environment of elevated rates, what was a benefit for many years for equities will likely be a drag. 2022 wasn’t too long ago and was a good example of this when hedge funds outperformed equities by 10-15%.
For an investor building a portfolio today who is looking at a hedge fund allocation funded by a reduced equity allocation, the biggest question is whether to expect a return to near zero rate policy or could rates remain elevated for some time. A return to the unprecedented easy money of the post-GFC period would clearly benefit equity index investment over an allocation to diversified hedge fund strategies, but that looks relatively unlikely to occur.
It is time to start preparing for an environment where easy money isn’t the norm. Hedge funds have a strong track record of maintaining their performance during such times, while equities have done poorly for fundamental reasons. While it is easy to shy away from diversified alpha given the recent strength of stocks, it comes down to placing an important bet – what is more likely for the future: a return to the easy money days or tighter policy than many expect?
For informational and educational purposes only and should not be construed as investment advice. The historical analysis discussed herein has been selected solely to provide information on the development of the research and investment process and style of Unlimited. The Hedge Fund Index referenced herein is calculated by averaging the hedge fund index monthly returns from BarclayHedge, Bloomberg, HFRI, and Credit Suisse when those indexes are available, then adds back estimated fees to estimate a gross return. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein.
