The Risk in Hedge Funds as a Portfolio Hedge

Yesterday, one of our favorite bloggers, Josh Brown over at The Reformed Broker, took to the defense of the hedge fund industry after one of our favorite writers Matt Taibbi at Rolling Stone fired a shot across the bow earlier in the week. While Taibbi says hedge funds “suck at investing” because they are all underperforming the S&P this year, Brown argues the point that most people turn to hedge funds for risk-adjusted return (or, at least, they should). It’s not about out-performing a rallying stock market, but (hopefully) earning a respectable return (and a better risk-adjusted return) whether the market goes up or down.

For Brown, while many hedge funds will tout alpha as a major selling point, at the end of the day, most of them simply sacrifice some upside volatility with the intention of avoiding a great deal of downside volatility, too.  Josh goes on to say that there are “some hedge fund managers who are simply beta+leverage” (meaning leveraged bets on the stock market), but that most managers are not chasing Apple or the stock market in general, instead doing other things like “volatility, credit arb, emerging markets, commodities, and on and on”.  (C’mon Josh, you couldn’t give us some managed futures love?)

So we have Taibbi on one side essentially asking why we are paying hedge funds managers millions to just chase the stock market, and Brown on the other saying – hold on, only some chase it, and even those who chase it do so in a way that the results can definitely be something less (in terms of returns and risk) than the stock market.

We’re left thinking they both miss the point, which is a little more nuanced than perhaps either of their audiences want to consider. You see, while hedge funds are doing a lot of different things and not trying to simply beat the market (props Josh Brown), one need only look at 2008 and the severe losses seen by most hedge fund categories to give merit to the idea that many are chasing the stock market (props Matt Taibbi).

The nuanced point is that no matter what hedge funds try and do to provide, as Josh Brown put it,  “an alternative for wealthy investors so that even in tough times, they have someone who can play the short side or find other ways to make money when stocks aren’t rising,” the recent proof in the pudding of 2008 showed that they are still tied to the stock market. Why? It’s complicated, but the quick and easy reasons are because they rely on access to credit just like the companies in the stock market, and that many (even those doing arbitrage or similar) are betting on the success or failure of companies which succeed or fail in sync with the economy (much like the stock market).

So, in our opinion, they are both sort of right, and both sort of wrong.  As you can see below – Brown’s defense is more applicable to some corners of the hedge fund world than others (hint: managed futures), while Taibbi’s argument was more applicable to some categories in 2008 than others (mainly emerging markets and equity neutral).

* Source: Dow Jones Credit Suisse Hedge Fund Indices (Disclaimer: past performance is not necessarily indicative of future results.)

At the end of the day, whether hedge funds outperformed stocks this year may be missing the point. While we don’t know what the next crisis will bring, 2008 at least showed us that not all hedge fund categories are made of the same stuff when it comes to crisis period performance – and that’s the time investors are likely looking for hedge funds to do their job.  So, we’ll disagree with Taibbi and say that hedge funds are a better equity play than just investing in the stock market (on a risk adjusted basis), but also realize that when it comes to providing cover in a storm – it’s safe to say that most hedge funds are not the magic bullet investors are looking for.

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