Equity advance/decline ratio key indicator for hedge fund performance

Equity advance/decline ratio key indicator for hedge fund performance

A study by Hennessee Group has 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 three to one (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),” says Charles 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.” 

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 23 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 three times the number of winners than losers. 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. 

During 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 per cent 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. 

In January, the S&P 500 Index declined 3.7 per cent with 133 issues up and 366 issues down. Consistent with the results over the last 23 years, the breadth ratio of 0.4 proved favourable 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,” says 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.”

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