4 ms·
The correct benchmark for a hedge fund is T-bills, not the S&P or the Nasdaq. That's because hedge funds are an absolute return product that offers an income st
by dcolkitt 6y ago
The correct benchmark for a hedge fund is T-bills, not the S&P or the Nasdaq. That's because hedge funds are an absolute return product that offers an income stream uncorrelated to the market.
This may sound counterintuitive, but it's the basis of modern portfolio theory. The price that an investor should be willing to pay for an investment has to do with its beta to the broader market.
Think of it this way, imagine you could access the S&P 500 in a parallel universe. It has the same return characteristics as the normal S&P 500, but in any given year moves independently. How much does this improve your portfolio? Intuitively you'd think it's not worth anything. It's only as good as your current investments, so what's the point.
But in fact modern portfolio theory tells us that it's a huge improvement. Investing 50/50 in S&P and Bizarro-S&P, substantially improves the amount of return you can access for the same risk. That's because the two diversify each other, and the blend either reduces risk by 30% or lets you leverage up and increase expected returns by 30%.
You're saying, "maybe Melvin isn't a good investment, because it seems about equal to the S&P". But the point is an investment that's about equal to the S&P, yet uncorrelated to the S&P is massively valuable. Even if it has big drawdowns, you typically don't care as long as those drawdowns tend to occur during times when the rest of your portfolio is doing fine.
This is the same reason that a 60/40 stock-bond portfolio has massively outperformed 100% stocks historically. Even though bonds themselves return less than stocks.
- letsgoyeti 6y agoThanks for the explanation - one question though, how do we know that Melvin (or any other security/fund) is not correlated to the S&P?
- dcolkitt 6y agoTo be fair, it probably is. Most equity hedge funds are probably closer to a 50% correlation, and should be benchmarked accordingly (i.e. half T-bills/half S&P). Investors would be able to see its historical monthly returns and regress them against the equity index.
- runako 6y agoThis is good background and all makes sense, but in the context of Melvin we don't have enough data to know whether any of this is true in their case vs just being part of their pitch. (This is essentially true of all hedge funds.) What appears to be the case is they were edging the QQQ until they incinerated half their capital in a week on a bad bet and poor risk controls. So we now know they are uncorrelated with the S&P, but unfortunately we only know they are uncorrelated to the downside. (We don't know if their outperformance has been a result of real alpha or a strong market plus leverage.) We saw a lot of these funds in the strong bull market of the 90s and the takeaway I remember was that it's impossible to know ahead of time who's going to blow up and lose all/most of your money.
- koonsolo 6y ago> Investing 50/50 in S&P and Bizarro-S&P, substantially improves the amount of return you can access for the same risk. I can see how this would lower the volatility of your portfolio. But how do you improve the return in this scenario? > This is the same reason that a 60/40 stock-bond portfolio has massively outperformed 100% stocks historically How is this possible? If I invest 100% in stocks, my return after 10 years is higher than 60/40 stock-bond. So why do you say the latter outperforms it?
- londons_explore 6y ago> I can see how this would lower the volatility of your portfolio. But how do you improve the return in this scenario? Leverage. You can translate reduced risk into greater returns by getting loans to invest more.
- lultimouomo 6y agoWhen the stock crashes, you can sell some bonds, which have not crashed, and buy stock on the cheap. When the stock recovers, you sell some stock and buy bonds. Rinse and repeat. (You don't need to try and time the market for this to work. You can have a threshold so that you rebalance when you deviate from your target allocation more than X%)
- koonsolo 6y agoI don't see how this would outperform 100% stocks over 10 years. Or in other words, show me the numbers.
- Erwin 6y agoYou can use a site like this to compare: https://portfoliocharts.com/portfolio/total-stock-market/ https://portfoliocharts.com/portfolio/total-stock-market/ versus https://portfoliocharts.com/portfolio/classic-60-40/ https://portfoliocharts.com/portfolio/classic-60-40/ Mixing bonds gives you a slightly higher safe withdrawal rate but you do lose 2 percentage points average yearly returns.
- hasperdi 6y agoThanks for the informative comment. Could you give some pointers where I can learn more about this modern portfolio theory?
- Voloskaya 6y ago> The correct benchmark for a hedge fund is T-bills T-Bills are virtually risk free, which is not the case of hedge funds, so why would you compare one with the other? > But the point is an investment that's about equal to the S&P, yet uncorrelated to the S&P How can you say that a hedge fund's return and the S&P are uncorrelated? They may not be identical but they are very strongly correlated.
- gvhst 6y agoMany hedge fund's run a factor neutral (market + other risk factors are hedged out of the portfolio) long short book. If done right (and thats the catch) there should be low correlation to S&P. T-bills are the performance benchmark for hedge funds but not the risk benchmark (which is generally something riskier). This can sound counterintuitive as T-bills are a very low hurdle to clear. However, in a downturn scenario generally causes rates to fall, increasing t-bill return when the rest of the market goes down. In that case its a very difficult hurdle to clear.
- Voloskaya 6y agoDo you happen to have any resource that dives into this? This is really interesting would love to know more about how this works in details.