22 Jul 2010
The health of the global economy and the sovereign debt crisis remain the central concerns to investors in 2010. As worries mount, investors are once again questioning the state of the financial markets and are increasingly looking for ways to minimize losses and protect capital in the event of another significant market correction. The Hennessee Group analysed its Hennessee Hedge Fund Indices to determine which strategies have outperformed the S&P 500 Index during times of crisis, specifically which hedge fund strategies generated attractive risk-adjusted returns while providing downside protection.
In its analysis, the Hennessee Group first isolated the worst five drawdown periods for the S&P 500 Index dating back to 1993 and used the three main Hennessee Hedge Fund Sub-Indices as proxies to identify which hedge fund strategies have historically protected capital the best during strong market sell-offs. While all hedge funds strategies provide significant downside protection, analysis shows that non-directional strategies, such as arbitrage and event driven strategies, were best at minimizing drawdowns, protecting capital and lowering volatility.
Sovereign Debt Crisis (May-10 to Jun-10): The growing sovereign debt crisis has put into the question the sustainability of the global economic recovery and has subsequently resulted in a sharp sell-off in the equity markets in 2010. Despite a double digit loss for the S&P 500 Index, all hedge fund sub-strategies have participated in a third or less of the drawdown. The Arbitrage/Event Driven Index protected capital best with a -2.5% loss versus a -13.2% loss for the S&P 500 Index.
Credit Crisis (Nov-07 to Feb-09): What started out as a serious credit crunch evolved into a much broader financial crisis that resulted in a widespread economic slowdown and massive sell-off across nearly every asset class. The Arbitrage/Event Driven Index provided the most protection, participating in only 36% of the drawdown (-19.3% vs. -52.6% for S&P 500). Merger arbitrage (-1.2%), fixed income (-8.5%) and multiple arbitrage (-13.2%) were particularly strong performers on a relative basis during this time period.
Tech Bubble (Sep-00 to Sep-02): The bursting of the technology bubble was another challenging period for the financial markets. The Hennessee Arbitrage/Event Driven Index generated a gain of +8.4%, as the S&P 500 Index fell -46.3% over the same time period. Convertible arbitrage (+16.6%), multiple arbitrage (+18.2%) and merger arbitrage (+5.5%) were particularly strong performers during this time period.
Long-Term Capital Management (Jul-98 to Aug-98): The markets came under pressure in 1998 due to the Russian debt crisis and the failure of Long-Term Capital Management. The Hennessee Arbitrage/Event Driven Index once again was the top performing index, participating in only a third of the S&P 500 Index drawdown (-5.1% vs. -15.6% for S&P 500). Multiple arbitrage (-2.6%), convertible arbitrage (-3.0%), and merger arbitrage (-3.7%) were particularly strong performers on a relative basis during this time period.
Bond Meltdown (Feb-94 to Jun-94): Rising global interest rates in 1994 caught investors off guard and caused bond prices to plunge dramatically. The Arbitrage/Event Driven Index and Long/Short Equity Index were able to once again protect against the -7.8% drawdown in the S&P 500 Index. The Arbitrage/Event Driven Index slipped only -0.1% over the same time period, led by managers in event driven (+7.1%), distressed (+4.2%), and multiple arbitrage (+2.6%).
The downside protection of hedge funds is also evident when analysing the monthly returns of the Hennessee Hedge Fund Indices versus the S&P 500. In months when the S&P 500 declined in value, hedge funds, on average, participated in less than 30% of the loss. The Hennessee Arbitrage/Event Driven Index was once again the most successful at protecting capital in down markets with an average loss -0.1% a month versus the S&P 500 Index average loss of -3.9%. The Hennessee Long/Short Equity Index generated an average loss of -0.9%, while the Hennessee Global/Macro Index averaged a loss of -1.0%.
The ability to protect capital in the down markets has allowed hedge funds to greatly outperform the S&P 500 Index on both an absolute and risk-adjusted basis. Since 1993, all three Hennessee Group Hedge Fund Sub-Indices have outperformed the S&P 500 Index with a fraction of the volatility. While the Hennessee Long/Short Equity has been the top performer on an annualized return basis (+10.2%), the Hennessee Arbitrage/Event Driven Index has generated a comparable return of +9.9% with lower volatility. The Arbitrage/Event Driven Index has generated the highest Sharpe ratio among the hedge fund indices and is much higher than S&P 500 Index (1.81 vs. 0.52).
With the numerous head winds that still remain for the economy and financial markets, the Hennessee Group believes it is important for investors to not only revisit their overall allocation to hedge funds, but also think strategically about their underlying hedge fund strategy exposures to identify which are most likely to outperform going forward, particularly in the event of a market-sell-off. As seen in this analysis, while all hedge fund strategies have provided excellent downside protection in prior bear markets, as well as good risk adjusted returns over the longer-term, certain hedge fund strategies, namely non-directional strategies in the arbitrage category, have historically shown the greatest ability to protect capital during market downturns. Depending on one’s own risk/return objectives, investors should give consideration to non-directional, arbitrage strategies when constructing hedge fund portfolios, particularly as we continue to navigate through these uncertain times.
In its analysis, the Hennessee Group first isolated the worst five drawdown periods for the S&P 500 Index dating back to 1993 and used the three main Hennessee Hedge Fund Sub-Indices as proxies to identify which hedge fund strategies have historically protected capital the best during strong market sell-offs. While all hedge funds strategies provide significant downside protection, analysis shows that non-directional strategies, such as arbitrage and event driven strategies, were best at minimizing drawdowns, protecting capital and lowering volatility.
Sovereign Debt Crisis (May-10 to Jun-10): The growing sovereign debt crisis has put into the question the sustainability of the global economic recovery and has subsequently resulted in a sharp sell-off in the equity markets in 2010. Despite a double digit loss for the S&P 500 Index, all hedge fund sub-strategies have participated in a third or less of the drawdown. The Arbitrage/Event Driven Index protected capital best with a -2.5% loss versus a -13.2% loss for the S&P 500 Index.
Credit Crisis (Nov-07 to Feb-09): What started out as a serious credit crunch evolved into a much broader financial crisis that resulted in a widespread economic slowdown and massive sell-off across nearly every asset class. The Arbitrage/Event Driven Index provided the most protection, participating in only 36% of the drawdown (-19.3% vs. -52.6% for S&P 500). Merger arbitrage (-1.2%), fixed income (-8.5%) and multiple arbitrage (-13.2%) were particularly strong performers on a relative basis during this time period.
Tech Bubble (Sep-00 to Sep-02): The bursting of the technology bubble was another challenging period for the financial markets. The Hennessee Arbitrage/Event Driven Index generated a gain of +8.4%, as the S&P 500 Index fell -46.3% over the same time period. Convertible arbitrage (+16.6%), multiple arbitrage (+18.2%) and merger arbitrage (+5.5%) were particularly strong performers during this time period.
Long-Term Capital Management (Jul-98 to Aug-98): The markets came under pressure in 1998 due to the Russian debt crisis and the failure of Long-Term Capital Management. The Hennessee Arbitrage/Event Driven Index once again was the top performing index, participating in only a third of the S&P 500 Index drawdown (-5.1% vs. -15.6% for S&P 500). Multiple arbitrage (-2.6%), convertible arbitrage (-3.0%), and merger arbitrage (-3.7%) were particularly strong performers on a relative basis during this time period.
Bond Meltdown (Feb-94 to Jun-94): Rising global interest rates in 1994 caught investors off guard and caused bond prices to plunge dramatically. The Arbitrage/Event Driven Index and Long/Short Equity Index were able to once again protect against the -7.8% drawdown in the S&P 500 Index. The Arbitrage/Event Driven Index slipped only -0.1% over the same time period, led by managers in event driven (+7.1%), distressed (+4.2%), and multiple arbitrage (+2.6%).
The downside protection of hedge funds is also evident when analysing the monthly returns of the Hennessee Hedge Fund Indices versus the S&P 500. In months when the S&P 500 declined in value, hedge funds, on average, participated in less than 30% of the loss. The Hennessee Arbitrage/Event Driven Index was once again the most successful at protecting capital in down markets with an average loss -0.1% a month versus the S&P 500 Index average loss of -3.9%. The Hennessee Long/Short Equity Index generated an average loss of -0.9%, while the Hennessee Global/Macro Index averaged a loss of -1.0%.
The ability to protect capital in the down markets has allowed hedge funds to greatly outperform the S&P 500 Index on both an absolute and risk-adjusted basis. Since 1993, all three Hennessee Group Hedge Fund Sub-Indices have outperformed the S&P 500 Index with a fraction of the volatility. While the Hennessee Long/Short Equity has been the top performer on an annualized return basis (+10.2%), the Hennessee Arbitrage/Event Driven Index has generated a comparable return of +9.9% with lower volatility. The Arbitrage/Event Driven Index has generated the highest Sharpe ratio among the hedge fund indices and is much higher than S&P 500 Index (1.81 vs. 0.52).
With the numerous head winds that still remain for the economy and financial markets, the Hennessee Group believes it is important for investors to not only revisit their overall allocation to hedge funds, but also think strategically about their underlying hedge fund strategy exposures to identify which are most likely to outperform going forward, particularly in the event of a market-sell-off. As seen in this analysis, while all hedge fund strategies have provided excellent downside protection in prior bear markets, as well as good risk adjusted returns over the longer-term, certain hedge fund strategies, namely non-directional strategies in the arbitrage category, have historically shown the greatest ability to protect capital during market downturns. Depending on one’s own risk/return objectives, investors should give consideration to non-directional, arbitrage strategies when constructing hedge fund portfolios, particularly as we continue to navigate through these uncertain times.
