By Bob Elliott, Co-Founder, CEO, and CIO of Unlimited, which uses machine learning to create index replication ETFs of 2&20 style alternative investments like hedge funds, venture capital, and private equity.
Over the past thirty years, hedge funds have proven an uncanny ability to avoid significant down-side risk in equities. By looking at the cumulative drawdown of hedge funds gross-of-fees, we can see that hedge funds have avoided some nasty corrections. Most notably, hedge funds drew-down some -5% through the dot-com bubble while the broader S&P 500 index dropped some -45% from its peak. Subsequently, hedge funds successfully navigated the financial crisis and the recent tumult in markets. While the S&P 500 was down more than -20% during 2022, hedge fund strategies only sold off by about -5%.
The data suggest that this drawdown protection is driven by hedge funds’ aggregate exposure to equity risk. Across funds, there may be substantial differences in market views and about which financial assets to hold for the prevailing environment, but, on average, the data show that hedge funds have successfully managed their equity exposures against economic turmoil. Here we can see that average hedge fund beta to equities (proxied with the S&P 500) has varied over time and that decreases in equity risk have roughly preempted sell-offs in equity markets. Notably, hedge fund managers have dialed back their equity exposure significantly since 2021. With a current equity beta of 0.2, hedge funds are about as bearish on stocks now as they ever have been.
Through the end of July, the S&P 500 is up nearly 20% YTD. Meanwhile, hedge funds have returned mid single digits. But the data make a strong case for hedge fund strategies over time. While the bias of hedge funds towards capital preservation looks less attractive during short periods of strong bull markets, the data show that this prudent risk management has effectively generated returns while mitigating losses over the long-haul.
About the Author:
Bob Elliott is the Co-Founder, CEO, and CIO of Unlimited, which uses machine learning to create index replication ETFs of 2&20 style alternative investments like hedge funds, venture capital, and private equity.
Prior to founding Unlimited, Bob was a Senior Investment Executive at Bridgewater Associates where he served on the Investment Committee (G7) and created investment strategies across equities, fixed income, credit, exchange rates, and commodities, including many used in the flagship Pure Alpha fund. He also built and led Ray Dalio’s personal investment research team for nearly a decade. He’s the author of hundreds of Bridgewater’s widely read Daily Observations and directly counseled some of the world’s foremost policymakers and institutional investors on economic and investing issues.
Bob has also served as an advisor and executive at several startups including CircleUp, an investment company focused on early-stage consumer brands. There he revamped the investment strategy for the company’s $150mln venture funds leveraging big data approaches to improve decision-making. He was also the co-founder of GiveWell, a startup charity evaluator which now directs more than $500mln in annual contributions.
Bob holds a BA in History and Science from Harvard.