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Comment: Long/short equity funds under-performance in 2004 is due to low volatility and high market coherence rather than money overflows

Raphael Douady, Research director, Riskdata, looks at the reasons underlying last year's performance by long/short equity funds.


We frequently hear that the overflow of capital into alternative investment dampens performance, because arbitrage opportunities dry up. Indeed, hedge funds play market inefficiencies, which appear in limited amounts, therefore capping tradable amounts. However, our research suggests that the story is not so simple.


Let's take the example of long/short equity funds. Our analysis shows that the major drivers of 2004 under-performance were the low volatility and high degree of coherence of markets, rather than money overflow.


In 2003, the EDHEC index performance for this sector was +18 per cent. In 2004, the same index gained only 8.5 per cent, out of which 5 per cent was achieved in November and December alone. We know that many people point the blame at the overflow of capital into alternative investment.


In fact, running an appropriate non-linear factorial analysis over the time period 2001-03 yields the following interesting results:


• The index was globally long the market, especially small and microcaps, unlike its components, which are rather market neutral;

• It under-performs when the level of coherence across industrial sectors is either above a threshold (65-70 per cent), or, on the opposite, when sectors are too uncorrelated (below 30 per cent); and

• It also under-performs when there is not enough volatility (below 15per cent annualised) or, on the contrary, too much of it (above 30 per cent annualised).


With this background in mind, what happened in 2004?


Markets have never been so coherent (correlation index 60-85per cent); and simultaneously, volatility reached a historical low, in the range of 7-10 per cent annualised.


In other words, markets were such that, regardless of the amounts invested, trading opportunities vanished for statistical reasons, rather than macro-economical ones.


Moreover, it is highly probable that, as soon as volatility is back and markets become less coherent, long/short equity funds will perform again, as this seems already to be the case in February 2005.


Our study shows that long/short equity funds under-performance in 2004 was mostly due to the low volatility and high degree of coherence of markets, rather than money overflow. We've made similar studies for many other strategies: convertible arbitrage, statistical arbitrage, event driven, etc.


In conclusion, a bad reason, for institutional investors, to choose to invest in alternative vehicles is to purely seek alpha. The good reason for alternative assets is the fantastic diversification opportunity they offer, not only across fixed income, equities, commodities, but also through volatility, coherence, convergence, etc.


Background notes: Riskdata's team includes risk management experts, investment practitioners and IT specialists. Its aim is to offer money managers easy, interactive and intuitive access to any risk analysis. It is supported by leading figures, such as Professor Robert Mundell, a past winner of the Nobel Prize for Economics.


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