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Hennessee study shows hedge funds generally lag their traditional counterparts when equity markets experience strong advances

Tuesday, February 23, 2010
Opalesque Exclusive – Hennessee Group LLC, a consultant and adviser to direct investors in hedge funds, recently conducted a study examining the correlation between the breadth of equity market moves and the performance of long/short equity hedge funds relative to traditional indices. Through this study, the Hennessee Group confirmed that hedge funds generally lag their traditional counterparts when the equity markets experience strong advances and winners greatly outnumber losers as witnessed in 2009. Conversely, when the markets experience a more balanced move or a meaningful move to the downside, hedge funds generate significant alpha on a relative basis.

“Hennessee Group research indicates that in market advances where winners outnumber losers by more than 3 to 1 (breadth ratio of 3.0), hedge funds generally struggle to differentiate themselves as performance is strongly driven by momentum (beta) as opposed to strong stock selection (alpha),” stated Mr. Gradante, Managing Principal of Hennessee Group. “During such strong, broad based gains, hedge funds have a particularly difficult time identifying good shorting opportunities as there can be a disconnect between fundamentals and stock performance. Therefore, short positions generally serve as a drag on performance in these markets.”

Ratio of Winners to Losers Historically a Strong Indicator of Relative Performance

The Hennessee Group evaluated the performance of the Hennessee Long/Short Equity Index against the S&P 500 Index while also taking into consideration the breadth of the equity markets each calendar year period dating back to 1983. Over these twenty three calendar year periods, the Hennessee long/short equity index underperformed the S&P 500 Index ten times. During nine out of those ten calendar year periods, the Hennessee Group found that the S&P 500 Index experienced at least 3 times the number of winners than losers (the lone exception we observed was 1998 when Long-Term Capital Management meltdown which caused distress in the hedge fund industry). To illustrate, in 2009, 425 of the S&P 500 Index constituents experienced gains while 73 experienced losses. With over five stocks up for every one stock down for the year, hedge fund managers found it very difficult to successfully add value with strong selection, particularly on the short side. The most profitable portfolio strategy in such an environment was to increase net exposure and lever the portfolio to benefit from the beta driven market. That said, while hedge funds generally lagged in such beta driven environments, they still managed to perform well as the Hennessee Long/Short Equity Index generated positive returns each calendar year, with double digit gains in eight of the ten.

Breadth Analysis
Source: Standard & Poor’s, Hennessee Group LLC

Year

Up Stocks

Down Stocks

Breadth Ratio

S&P 500

Hennessee L/S Equity

Alpha

2009

425

73

5.82

24.70%

21.70%

-3.00%

2008

25

470

0.05

-38.40%

-18.60%

19.80%

2007

245

246

1

3.50%

11.70%

8.20%

2006

369

120

3.08

13.60%

11.00%

-2.50%

2005

286

213

1.34

3.00%

6.70%

3.70%

2004

378

120

3.15

8.90%

7.70%

-1.20%

2003

458

41

11.17

26.30%

19.40%

-6.90%

2002

131

368

0.36

-23.30%

-6.40%

16.90%

2001

213

285

0.75

-13.00%

2.80%

15.90%

2000

273

220

1.24

-10.10%

10.20%

20.30%

1999

241

256

0.94

19.50%

33.80%

14.30%

1998*

289

206

1.4

26.60%

+7.2%  *

-19.30%

1997

400

96

4.17

31.00%

19.90%

-11.00%

1996

364

130

2.8

20.20%

18.00%

-2.10%

1995

424

67

6.33

34.10%

21.10%

-13.00%

1994

202

294

0.69

-1.50%

3.40%

5.00%

1993

326

168

1.94

7.00%

20.00%

12.90%

1992

330

166

1.99

4.40%

15.70%

11.20%

1991

401

94

4.27

26.30%

22.20%

-4.00%

1990

133

359

0.37

-6.50%

11.00%

17.60%

1989

379

119

3.18

27.20%

22.60%

-4.50%

1988

361

137

2.64

12.40%

17.50%

5.10%

1987

229

267

0.86

2.00%

14.80%

12.70%

Averages

294

175

2.59

8.62%

12.81%

4.19%

Breadth Ratio = up stocks divided by down stocks
* Long-Term Capital systemic risk.


The remaining 13 calendar year periods when the Hennessee Long/Short Equity Index outperformed the S&P 500 Index, the market moves were more generally balanced with a breadth ratio consistently less then three; providing long/short equity managers with a greater opportunity set to generate alpha on both sides of their books. Of particular note is 1999 when the S&P 500 Index experienced a strong +20% gain. Despite the strong equity rally, hedge funds managed to outperform the traditional index as the breadth of the move was more evenly balanced relative to other equity market rallies (breadth ratio of 1.06) allowing managers to generate alpha through strong stock selection. During other calendar year periods with low breadth ratios, hedge funds generated double digit alpha relative to the index irrespective of market direction.

2010 Outlook

In January, the S&P 500 Index declined -3.7% with 133 issues up and 366 issues down. Consistent with the results over the last 23 years, the breadth ratio of 0.4 proved favorable to hedge funds on a relative basis as the Hennessee Long/Short equity Index outperformed the S&P 500 by 280 basis points. A distinguishing factor between hedge funds and traditional equity investing in January was the ability to generate alpha with short positions and market hedges. The greater the universe of shorting opportunities, the greater the likelihood hedge funds will outperform their traditional counterparts, particularly during market downturns.

“In 2009, hedge funds most willing to take on greater net long exposure and bought high beta stocks were most rewarded while those funds that remained defensively positioned, with low net long exposure and an emphasis on fundamentals, generally lagged” said Mr. Gradante. “We believe 2010 will be different. We anticipate greater dispersion among sectors and stocks and a more balanced advance/decline ratio as fundamentals come into main focus again.”


Hennessee Group LLC is a Registered Investment Adviser that consults direct investors in hedge funds on asset allocation, manager selection, and ongoing monitoring of hedge fund managers. Hennessee Group LLC is not a tracker of hedge funds. The Hennessee Hedge Fund Indices® are for the sole purpose of benchmarking individual hedge fund manager performance. www.hennesseegroup.com.


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