market folly

Burnham Banks has penned an interesting comparison of conditional probabilities between hedge fund returns and equity market returns on a monthly basis. For this study, he used the MSCI World Equity Index and the HFRI Hedge Fund Index.

He finds that:

- Since January 1997: when equities are down, a hedge fund's chances of losing money are 69% and when equities are up, a hedge fund's chances of losing money are 7%.

- Since January 2008: when equities are down, a hedge fund's chances of losing money are 81% and when equities are up, a hedge fund's chances of losing money are 4%.

It should obviously be noted that the second date range is skewed by the financial crisis as large equity declines saw large drawdowns at various hedge funds. At the same time, snap-back rallies in 2009 and 2010 also influenced things.

The numbers are intriguing, though, when you consider that in 2011, many hedge funds lagged their respective indices. While many attributed this to having inappropriate gross/net exposures, it could have also just merely come down to market timing as the Wall Street adage, 'sell in May and go away' held true and the market declined precipitously in the second half of the year.

One thing to consider is that the article says "forget about correlations." And on that issue, we'd highly recommend reading excerpts from Maverick Capital's investor letter. In it, founder Lee Ainslie addresses correlation, writing:

"Last year intra-stock correlations reached all-time highs, surpassing even the levels seen in 1929 and 2008. In other words, stocks moved in tandem with one another to a degree never before seen and were less responsive to idiosyncratic risks, such as fundamental factors, than ever before. Such an environment is clearly challenging for long/short investors who rely upon stock prices being responsive to fundamental differences among companies."

So when viewing the conditional probabilities above, you certainly have to keep in mind that the narrow, more recent date range includes two years (2008 and 2011) where correlations reached extremes and certainly affected hedge fund performance. You can read the article here.