Sand Spring Advisors LLC

Why the HFR Fund of Funds Index is Unnecessarily Correlated to the Equity Market

June 1, 2000


Barclay T. Leib

In May on behalf of, we explored why private pension fund managers tend to shun hedge fund and CTA investing, opting instead to consider private equity and LBOs as their "alternative" assets of choice. Logical reasons cited by industry observers included: a natural proclivity toward performance-chasing, a certain familiarity of product, job security, the psychological appeal of not marking-to-market, and hedge fund capacity issues.

We suggested that there are potential problems with such styled pension fund behavior. Pension managers specifically risk the creation of suped-up fee-intensive equity investing in disguise -- something ripe to cause disappointment should the bull market in equities continue to wane.

But if there are logical excuses (if not a definitive good reason) to explain why the pension fund managers still shun investing with hedge funds and CTAs, another question can be posed. Why does the HFR Fund of Funds Index still tends to run between 50% and 65% correlated to the S&P 500, depending upon the time horizon one examines. Aren't fund of funds by design supposed to provide some diversity of trading style to get away from pure equity exposure?

Here the answer once again appears to be multifold.

An Overly Broad and Perhaps Dated Index
First, and quite obviously, not every fund of funds has a mandate to actually be market neutral. Among the universe of neutral fund of funds run by firms such as Grosvenor, Harris Associates, Mesirow and Glenwood - the big four Chicago-based fund of funds powerhouses -- there are a number of other offerings that by design purposefully include a long bias. Two of the older of these are the Optima Funds and Leveraged Capital Holdings funds that one source suggests may have dominated the HFR index when it was first formed.

"I do not really understands what the HFR indices represent. They don't tell me the underlying managers," says Remi Bouteille, a hedge fund consultant at Lake Partners. "Since the index was created sometime ago, when people were looking at the hedge fund community less for its lack of correlation and more for its absolute returns, the managers included in the supposedly neutral subindices may have no mandate to keep their products uncorrelated, but simply to beat the S&P with a moderate control of the downside."

Roxanne Martino, President of Harris Partners, Chicago, thinks that the answer to understanding the HFR Fund of Funds Index is as simple as the managers allowed into it. "You don't have to be multi-strategy to be included their index, just multi-manager" explains Martino. "Thus it includes apples and oranges. Along with all the market-neutral managers included within the index, you have other fund of funds that are multi-manager but all tech, or all Pacific Rim, or all Japan. Of course you are going to get positive correlation. It doesn't surprise me at all."

Joseph Nicholas, President and Founder of HFR, claims that his company's fund of funds index is a good representative mix of almost 400 fund of funds managers, but that since most underlying hedge funds of course make their living trading stocks, a positive correlation is almost bound to show through. He advises caution however reading too much into this: "While both the hedge fund composite and the fund of funds composite [indices] have been correlated to the S&P 500 [over the last three years], this correlation is accompanied by low beta statistics, mitigating the effect of correlation on returns."

This is a fancy way of saying that while the correlations may at first blush appear high, statistics cannot definitively determine whether this is truly important or simply accidental. Since the HFRI Fund of Funds has only had a beta to the S&P 500 of 27.04% since 1997, Nicholas feels that statistically one shouldn't be too concerned. The directional movement of returns may have been similar, but not the attributable magnitude.

Long Equity in Drag
Notwithstanding this statistical caveat, there are other anecdotal and qualitative views that still point to an industry not working particularly hard to bury a positive equity bias.

Brian Cornell of Mesirow Financial points to ex-Wall Street investment bankers who set up fund of funds in their twilight years as another focal point.

"There are some fund of funds out there, mostly New York-based, that are just mutual fund managers in drag," he argues. "These managers are attracted by the higher fees of a fund of funds structure, but they are basically doing long equity. The character of their hedges are either small in nature and/or index oriented rather than stock specific."

Sage Capital, founded by former Goldman Sachs partners Robert Friedman and Peter Levy might be one example of a New York-based fund of funds that does not shy away from long equity exposure. Their LP offering's recent correlation to the Russell 2000 has been running at a fairly lofty 69%. Gordon Associates is another Westchester-based fund of funds that has approximately a 67% allocation to equity-oriented strategies of which 40% is allocated to the technology sector.

Another fund of funds firm, Mezzacappa Berens, founded by two former Wall Street investment bankers Damien Mezzacappa and Rodney Berens, asserts in marketing material that the S&P 500 compound return of 24.05% over the past 5 years "is not sustainable over time." Notwithstanding this view they choose to invest almost exclusively with long/short equity managers and maintain a 49% correlation to that index.

The temptation is clearly of easy returns by leaving a natural positive bias to equities in place. George Martin of the Center for International Study of Derivatives Markets at U-Mass, Amherst, tells a story of one well respected fund of funds who benefited last year from two managers jumping into a large amount of technology exposure in the last two months of 1999 and thereby delivering over 50% of that fund's annual return. "It's hard to walk away from that," he says. "Even though everybody knows at some point it could go the other way, it's hard to sit there and wait for that to happen."

Non-Desirous of CTAs
Many fund of funds managers also specifically exclude any Commodity Trading Advisors (CTAs) in their portfolio mix despite academic work showing the positive alpha attributes of doing so. This stems in part from a lack of understanding of CTA trading styles and trading edge in what many consider to be a zero-sum commodity world. It stems in part as well from the volatility of returns that CTAs occasionally serve up. "I just never know what CTAs are going to deliver," says one New Jersey based fund of funds manager, "and since I don't understand them, I don't include them."

CTAs also have had the burden of relatively high fees charged by some of their broker sponsors in structured fund offerings. "Although CTAs have often performed well in difficult times of market stress," says another fund of funds manager, "many people associate them with products launched over the last ten years by some of the big investment banks. The fee structures were so high, investors were never going to make much money."

So while the CTAs are out there ready to provide added alpha to a larger fund of funds portfolio -- thereby reducing that portfolio's equity market correlation -- many fund of funds managers shy away. They are either uncomfortable with the product, non-desirous of the fee structures, distateful of the sometimes unexpected volatility of CTAs, or simply happy with their pre-existing imbedded equity exposure.

A Heavy Component, No Matter What
Even when other non-equity investment styles are included in a fund of funds, there is one other statistical problem. George Martin of CISDM points out that equities are by far the most volatile asset class of any typical portfolio. "Unless you give an extremely small weighting to equity managers, the equity portion of any portfolio is going to dominate other things. Even in a fixed income arbitrage fund with just a small bit of equity, the volatility of unleveraged fixed income arb is so low, the equity portion will dominate in terms of volatility and correlation. You just can't escape it."

Watch Out for that VIX
Remi Bouteille has yet another theory consistent with some of the empirical occurrences of the 1998 market downdraft. Bouteille argues that many supposedly neutral strategies -- such as convertible bond arbitrage, merger arbitrage, and distressed investing - all still have a fairly strong equity correlation after a certain point in the equity Volatility Index (VIX) is reached. "Two years ago nobody looked at VIX," says Bouteille. "Now a number of people do. My theory is that some of these strategies benefit from volatility up to a certain point, but beyond that point, the markets that they are based on become illiquid. The strategies behave more or less like an option with an out-of-the-money knockout where BINGO you become short volatility. When the VIX goes above 60% all those strategies fall apart a bit."

Bouteille suggests that just a few fund of funds managers really understand this. "A number of people are putting together neutral products just by compiling 'neutral' managers, but to me this is not enough." Although Bouteille's own firm Lake Partners does not itself manage funds of funds (instead simply consulting for clients in manager selection), Bouteille points to one boutique firm, Weston Capital Management, as an example of a company structuring its manager portfolio differently in that respect.

"Weston is far more ambitious than just sticking a bunch of neutral managers together. They will take biased managers if they feel these managers are really adding value, and they will try to compensate for those managers with managers biased in the opposite direction. For example, they understand the wings of volatility and include some options managers and CTA exposure to help balance their spread/convergence traders. They look at the bias of their portfolio overall and adjust so that it behaves well at the extremes."

Indeed, Weston only has two modest offshore fund of funds offerings, their Wimbledon Class A and Class B shares, but these fund of funds show a statistical correlation to the S&P of just .16%. Despite all the wild gyrations in equities between 1997 and 1999, Wimbledon Class A's worst month was -.85% and the fund was up money in 34 out of 36 months. In the individual months between March 1997 and August 1999 where the S&P fell, their conservative Class A shares actually rose in value on nine out of ten occasions.

"These results are the product of a great deal of brainstorming," says Weston Chairman Albert Hallac. "We really wanted an all-weather product uncorrelated to the stock and bond markets. The raison d'Ítre of fund of funds should be to achieve good returns but let you sleep at night. To be a fund of funds manager and not work to eliminate one's positive equity correlation is a bit like cheating."

Going back to the strong disposition of pension funds to invest in LBO and private equity, Hallac maintains that "these type products shouldn't even be considered in the 'alternatives' class." He is adamant in this view, and joined in it by many others in the hedge fund world. But he is certainly not joined in it by many consultants.

"I think the hedge fund industry needs to move away from a proprietary claim on the term 'alternative investments,'" says Jeanne Murphy of consultancy firm Watson Wyatt, Atlanta. "Alternatives encompass a wide array of less-liquid and/or less efficient asset classes. Private equity may suffer a black eye if returns collapse in the wake of excessive cash flows, much as they did in the mid 1980's. But hedge funds already have a black eye, deserved or not, as a result of highly publicized failures and/or frauds, and changing the moniker to alternative investments looks like an attempt to hide behind a broader cloak."

So there we have it. To summarize both our article and today's investigative ponderings, it appears equity-based products continue to attract 75% of the net new flows into a broadly defined alternative investments universe. The pension fund managers and consultants think that this is just fine. On the other end of the spectrum, the savvy fund of funds fellows don't even think private equity belongs in their asset class, but the majority of them still sport a long equity exposure. How that exposure gets triggered appears something like a knockout option when market volatility goes from moderate to excessive, and normal liquidity evaporates. Many Chicago-based fund of funds managers and one or two East Coast ones strive toward that magic "zero level" of correlation, but many other fund of fund managers explicitly offer long-equity biased products. The HFR Fund of Funds Index itself may be a somewhat flawed hodge podge of managers that are not always multi-strategy, but in some cases simply multi-manager.

One thing is clear. Anyone who thinks alternative investments are all the same thing is working from a naÔve and incorrect assumption. Anyone who thinks that alternatives will be immune to an equity market downdraft better be choosing their alternative manager and strategy carefully.

Gobs of money are currently being thrown at private equity. With historical median returns suspect at best, this money is likely to meet with disappointing results. Mike Smith, a consultant with Frank Russell & Co. succinctly concludes: "It's no different than any other investment class that attracts masses of new money after producing strong results. The new money typically does not receive the returns that originally attracted them, better known as performance chasing."

With the above in mind, is the HFR Fund of Funds Index correlation to the S&P 500 likely to continue at 50% or above? Knowing which funds HFR includes in their index would obviously help to determine this. We suspect however that this index's equity correlation could move significantly lower, if not to zero, once the current era of equity performance chasing ends.

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Sand Spring Advisors provides information and analysis from sources and using methods it believes reliable, but cannot accept responsibility for any trading losses that may be incurred as a result of our analysis. Our advice should be deemed our personal opinion and not a recommendation to invest. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities, and should always trade at a position size level well within their financial condition. Principals of Sand Spring Advisors act as a fund of funds manager on a co-general partner basis with Weston Capital Management. Past performance of any of their funds cannot in any way guarantee similar future performance.
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