Target Volatility: Equity Hedge Funds’ Real Source of Alpha?
The argument over the value of active versus passive investing is never ending. Here, we make the case for active hedge funds and deliver a passive solution in Target Volatility.
According to BarclayHedge, the Hedge Fund Industry, excluding Managed Futures, has grown from $500 billion to $3.5 trillion during the 15-year period from 2002 through 2017. Here, we will analyze the major source of returns that comprise the Barclay Hedge Fund Index (BHFI) during that time.
There are 14 different categories of benchmarks that are listed by BarclayHedge. The risk-adjusted returns of the index are primarily determined by equity hedge fund strategies and strategies correlated to equity hedge funds. We estimate the index has 80% to 90% of its risk allocated to equity strategies or strategies that are highly correlated to equity strategies. Hedge funds, as represented by the BHFI, can effectively be viewed as equity replacements. Further, we also believe that the proper benchmark for Equity Hedge Funds are Target Volatility strategies. We will use the BHFI, and two of its categories, Barclay Equity Long Bias Index (BELBI) and Barclay Equity Long Short Index (BELSI), to represent equity hedge funds.
There are three issues we will address in this essay. First, the BHFI provides little diversification to traditional long-only equity indexes due to its high correlation. Second, equity hedge fund managers outperform traditional equity indexes on a risk-adjusted basis (this may or may not be surprising to some, but it was surprising to us). And third, we hypothesize that the reason for this outperformance is that hedge funds engage in a risk premia strategy called “intertemporal risk parity.” Other terms for this are Target Volatility and Constant Volatility.
In other words, this outperformance by BHFI over long-only equities can also be matched by using Target Volatility strategies. That is, Target Volatility equity strategies outperform long-only equity strategies by a similar amount, just as equity hedge fund strategies outperform long-only equity strategies (once fees are equalized). When lower fees are applied to Target Volatility strategies they, therefore, outperform Hedge Funds. Hence, the proper benchmark for equity hedge funds are not long-only equity indexes but Target Volatility equity strategies.
We are not aware of any studies that have discussed these three topics in an integrated fashion. If our combined hypotheses are accurate, this can have a significant impact on how one should view the performance of hedge funds.