Why Hedge Funds Benefit From The Asymmetry Of Returns

I wrote an article last month about why 50% of upside is not as good as 50% of downside is bad (see article here– Recap: A $100 million fund that rises 50% then falls 50% the following year will be left with $75 million. This asymmetry highlights the critical importance of understanding downside in portfolio management). I subsequently went out to lunch with a friend who is the marketing person from a fundamental long/short fund. We were discussing how some investors ding them for underperforming the market when the market rises and fail to give them credit for their positive relative performance in down-markets because they still lost money. This made me think of our previous example of the fund that started with $100 million and ended with $75 million. What if I just said that hedge funds only participated in 80% of that move, or 60% of the move, how would that change the results?
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This example shows that, at 80% capture of upside and downside, the loss is decreased to 16%. At 60%, this example shows a 9% loss. But this is an extreme example where loss is equal to gain, what if we dampened the loss to 30%?

This next example is interesting because we now have positive overall returns and we find that the best Capture (you can think of the Capture as amount of bankroll bet because betting a percentage equal to the capture would create the same return) is somewhere around 60%. Actually, the optimal bet is at 67% which I explain how to derive in my previous article on the Kelly Criterion. My friend also told me that his fund captures 63% of market upside and only 23% of market downside and that the Credit Suisse Long/Short Equity Index captures 62% of upside and 37% of downside. I thought it would be interesting to take market (S&P 500) historical returns and see how they would compare to just being long the S&P 500 given the favorable upside/downside capture of the Credit Suisse Long/Short Equity Index. This analysis does not use actual hedge funds results, but instead implied returns using the capture rates compared to the S&P 500. The results are interesting:
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Over the past 15 years, hedge funds have outperformed the S&P 500 due to the simple fact that they have smaller drawdowns. This leaves more capital to benefit in up markets even if the upswings are to a lesser degree. Even over longer periods of time where the S&P outperforms hedge funds, the hedge fund returns are subject to a lower standard deviation.
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Hedge funds are generally considered risky investments. But I believe the opposite is actually true for fundamental long/short funds that do not use excessive leverage. As the results bear out, hedge funds are better protectors of capital and are not damaged to the same degree as long-only strategies during down markets. The asymmetry of returns in compounding investments is a true "feather in the cap" for hedge fund investments and does not get the credit it deserves from some hedge fund investors. In fact, I believe the up 50%/down 50% example should be a component of every hedge fund manager's marketing documents. It highlights the true benefits of capital preservation for compounding investments inherent in hedge funds. If you would like Alpha Theory to help your fund analyze the impact of up-down capture in your portfolio and help you customize your presentation to investors, please contact us at info@alphatheory.com.