NEdge funds and the beta test of alpha

The reason we find market corrections so interesting is that they provide an opportunity, and the all-important data, to test the investment characteristics that we consider when performing analysis on hedge funds. While January has seen performance across the hedge fund industry improve, studying how funds perform in periods of market stress is invaluable to any investor.

Investors who allocate to hedge funds are seeking a few discrete outcomes – namely, performance, capital preservation and low correlation to traditional asset classes. The Aurum funds strive to deliver these three outcomes. Our view is that a portfolio that has low correlation to traditional asset classes is more likely to achieve performance and capital preservation. For portfolios that have performance as their primary objective, the siren song of the market can be very seductive – and unfortunately, for many hedge funds and investors, it was.

The challenge facing hedge fund investors today is identifying whether the real return that they are seeking is likely to be delivered. Unfortunately, many will be disappointed. Our analysis clearly shows that the majority of funds that describe themselves as hedge funds have not delivered the desired three outcomes of performance, capital preservation and low correlation to traditional asset classes.

A worryingly large proportion of the $3 trillion of hedge funds that Aurum tracks fall into a category that we refer to as ‘NEdge funds’, i.e. not exactly hedge funds. These NEdge funds may be structured in the same way as hedge funds, but have an investment style that is unlikely to reliably meet investor expectations of low correlation, performance and capital preservation.

To find out which funds fell into the hedge fund bucket versus the NEdge fund bucket we employed a simple test with the objective of answering a simple question – how did the funds fare across 2018, and during the fourth quarter, 2018’s most challenging period for risk assets, in particular? Drilling down further, how did hedge funds perform in December, a month that saw most hedge fund indices report negative returns across the board? We called this exercise the Beta Test of Alpha.

Of the ~4,000 funds that reported their returns to the end of December 2018, only 37% were positive in 2018. Furthermore, a mere 23% were positive in Q4 2018; 24% were positive in October; 44% were positive in November and 31% were positive in December. It seems that there are a lot of NEdge funds out there. We could do a lot more slicing and dicing, but these results led us to the conclusion that most funds failed the Beta Test of Alpha.

Identifying good hedge fund managers is like finding needles in haystacks. As the hedge fund industry has developed into a huge field of haystacks, the number of needles simply hasn’t kept up. It is only when there is a fire in the field, that the needles can be found.

A key characteristic of a hedge fund should be the ability to endure the inflection points as new market cycles develop. We may be at such a point, with global debt nearing record levels*, central bank balance sheets shrinking and geopolitical risks continuing. The next decade will be different to the last. Agility, focus and ability will be important qualities for any investment manager. And, when it comes to hedge funds, a singular focus on delivering the three outcomes should be enough to prevent their relegation to the NEdge category and failure in the next Beta Test of Alpha, when it comes.