Hedge Fund Factor Exposure & Alternatives

Summary:

Equity hedge fund returns have been disappointing over the last 14 years

An exposure analysis shows no structural factor exposure, but frequent factor rotation

Multi-factor long-short products are an interesting alternative, depending on the fee level

INTRODUCTION

Hedge fund assets reached an all-time high in 2017 with $3.3 trillion under management. Although returns were muted in recent years, investors have an interest to hedge equity risk given high equity multiples, record levels of debt and political uncertainties. However, the future of hedge funds, specifically of equity hedge funds, can be considered somewhat less attractive. Similar to the disruption of the mutual fund industry by plain vanilla and smart beta ETFs, equity hedge funds are increasingly being replaced by systematic, cheap, and transparent factor products. However, it is questionable how effectively hedge funds can be replaced with long-short factor products. In this short research note, we will analyze the factor exposure of equity hedge funds and compare the performance to a multi-factor long-short portfolio.

METHODOLOGY

We focus on the HFRX Equity Long/Short Index (Equity Hedge), HFRX Equity Market Neutral Index and the following factors: Value, Size, Momentum, Low Volatility, Quality, and Growth. The factors are constructed as beta-neutral long-short portfolios by taking the top and bottom 10% of the US stock universe and include 10 bps of transaction costs. The factor exposure analysis is a simple regression analysis with a one-year lookback.

HEDGE FUND PERFORMANCE

Before we start analyzing the factor exposure of equity hedge funds it is worth highlighting the performance of both indices. We contrast the performance to the S&P 500, which should not be considered as a benchmark for hedge funds, but merely serve as a reference point for the market cycle. We can observe that the Equity Long / Short Index, which tends to have some market exposure, generated a total return of 24.5% from 2003 to 2017 (1.5% pa); a somewhat disappointing performance given that this return is before inflation. The Equity Market Neutral Index, which has no market exposure, generated total return of 1.1% over the 14-year period (0.1% pa), which highlights the difficult nature of generating alpha and the impact of high fees.