We believe that the “magic” of manager alpha is inexorably intertwined with the forces of market volatility, both absolute and cross-sectional.
Magicians rely on the audience’s suspended disbelief and a lack of transparency. When both vanish, the entertainment value may not be worth the price of admission. We believe that investment managers can suffer a similar fate when markets narrow and potential outcomes become more obvious.
In the years leading up to the 2008 – 09 global financial crisis, manager alpha was plentiful, making it relatively easy picking for investors and allocators. To see this, take a look at figure 1 below. We used a simple regression analysis to illustrate what proportion of monthly excess returns over the risk-free rate came from volatility exposure (what we call “the ‘good’ stuff”) and equity index exposure (beta, or what we call “the ‘free’ stuff”), for a number of strategies over the longest common period prior to 2008.
The CBOE-based option indices can be parsed explicitly into volatility and equity exposure as those are the exclusive components of their potential outperformance. With respect to the HFRI Index, used as a hedge fund proxy, we accept the volatility component as a loose derivation of the strategy’s alpha ("the 'good' stuff") over the period.
Figure 1. A simplified breakdown of excess return components, January 1990 – December 2007
Source: Bloomberg, CBOE.
The results shown in figure 1 highlight the historical efficacy of equity long-short hedge funds, represented by the HFRI Equity Hedge Total Index (“HFRIEHI”), in offering a unique source of excess returns. The vast majority (~75%) of that excess return was attributable to “volatility” exposure, likely the result of a combination of unique stock exposures and dynamic hedging strategies, or simply the remnants after accounting for equity index exposure, or beta, which accounted for slightly less than 25% of the average monthly excess return. This compared favorably even to the performance of option strategy indexes, which in part derived returns directly from index volatility exposure, via index options: over half of the excess returns posted by option strategy indexes were attributable to index volatility exposures.
Abracadabra!
Then came 2008 – 2009 and the global financial crisis, a period of poor performance for both equity indices and hedge funds. Contrary to their history from 1990 – 2007, hedge funds also appear to have failed to profit from the volatility evident during this period.
By contrast, as one might expect, although overall excess returns were lower than before the financial crisis, the option-selling strategy indexes, PUT and BXMD, produced positive returns from their volatility exposure during these years, as figure 2 shows.
It’s also worth noting that the long-volatility exposure of the CLLZ index proved ineffective and expensive, despite this being a period of poor market returns and high volatility.
Figure 2. A simplified breakdown of excess return components, January 2008 – December 2009
Source: Bloomberg, CBOE.
Even more importantly, in the years since 2010, characterized by low rates and record equity market gains, hedge fund alpha continued to disappear, exposing lots of “hidden beta”—remember, this is “the ‘free’ stuff.”
Similarly, relatively restrained equity volatility levels have exposed the index beta that is often overlooked in index option strategy indexes. Figure 3 illustrates the dominance of equity index exposure in strategy returns since 2010.
Figure 3. A simplified breakdown of excess return components, January 2010 – January 2020
Source: Bloomberg, CBOE.
While tempting, we believe it’s a mistake to assume these indices all suffered from the same issue. The passive option writing strategy indices have simply been ‘overwhelmed’ by the S&P 500 Index’s historically strong gains, while there has been little market volatility to balanceout that effect. As one would expect, their respective profitability from volatility exposures declined.
The same cannot be said for active equity hedge fund strategies as a group. We realize the dispersion of returns with the hedge fund universe is large and acknowledge the unique managers that consistently create alpha. However, looking at the chart above, equity hedge fund strategies in aggregate appear to have subtracted meaningful value from their equity index exposures.
Illusions of Alpha
We can only hypothesize about the sources of this decline in value add. Hedging strategies, which create long-volatility exposure, may have been exceedingly costly. Dynamic trading strategies (risk-on vs. risk-off) may have struggled through the frequent periods of equity price reversals. Long-short stock selection may have underperformed the market despite reducing risk exposures at the portfolio level. Unintended factor exposures may have offset profits.
We believe that adjustments can be made to mitigate the decline of profitability from volatility exposures that has been experienced by passive option writing indices. Indeed, in the Option Group, this is one of our favorite topics of discussion. We believe understanding the underlying challenges of the equity hedge fund universe is much more complicated and uncertain, however.
Regardless of the strategy, we encourage all investors to continue to seek to understand when they may be paying for explicit “beta” in their portfolios and to be cautious of assigning the term “alpha” casually. Although many hedge fund numbers may have improved in 2019 on an absolute basis, investors should be cautious about illusions of “alpha.”