Hedge Fund Alpha: What about Drawdowns?

Abstract

The author reviews the relative risks of hedge fund investing using various commonly used measures, including market betas, correlations, and portfolio drawdowns. Historically, the data show that hedge funds have hedged a fair degree of systematic market risk, especially in the early years, offering meaningful diversification benefits to traditional stock/bond portfolios. However, the diversification benefits for investors in hedge funds have since declined, though they have not altogether been eliminated. Most recently, during the 2020 pandemic, modest drawdown benefits bore out for hedge fund investors, although again much less so than in the earlier years.

Key Findings

• ▪ This article extends “Hedge Fund Alpha: Cycle or Sunset” (Sullivan 2021) with a focus on the relative risk of hedge funds versus a stock-only as well as more diversified portfolios that seek to blend hedge funds, stocks, and bonds.

• ▪ The hedging away of systematic risk by hedge funds appears to be diminishing in recent years, in part due to rising correlations between stocks and hedge funds, now approaching 90%.

• ▪ Drawdowns for various hedge fund composite portfolios during the turbulent periods of 2008 and 2020 have been more in line with those seen by a traditional 50/50 stock/bond portfolio.

• ▪ However, within the universe of hedge funds, some strategies have delivered more meaningful diversification benefits.