The Hennessee Group has analysed its Hennessee Hedge Fund Indices to determine which strategies have outperformed the S&P 500 Index during times of crisis, and which strategies generated attractive risk-adjusted returns while providing downside protection.
In its analysis, the Hennessee Group first isolated the worst five drawdown periods for the S&P 500 Index dating back to 1993 and used the three main Hennessee Hedge Fund Sub-Indices as proxies to identify which hedge fund strategies have historically protected capital the best during strong market sell-offs.
While all hedge funds strategies provide significant downside protection, analysis shows that non-directional strategies, such as arbitrage and event driven strategies, were best at minimising drawdowns, protecting capital and lowering volatility.
The growing sovereign debt crisis has put into the question the sustainability of the global economic recovery and has subsequently resulted in a sharp sell-off in the equity markets in 2010. Despite a double digit loss for the S&P 500 Index, all hedge fund sub-strategies have participated in a third or less of the drawdown. The Arbitrage/Event Driven Index protected capital best with a 2.5 per cent loss versus a 13.2 per cent loss for the S&P 500 Index.
What started out as a serious credit crunch evolved into a much broader financial crisis that resulted in a widespread economic slowdown and massive sell-off across nearly every asset class. The Arbitrage/Event Driven Index provided the most protection, participating in only 36 per cent of the drawdown (-19.3 per cent vs. -52.6 per cent for S&P 500). Merger arbitrage (-1.2 per cent), fixed income (-8.5 per cent) and multiple arbitrage (-13.2 per cent) were particularly strong performers on a relative basis during this time period.
The bursting of the technology bubble was another challenging period for the financial markets. The Hennessee Arbitrage/Event Driven Index generated a gain of 8.4 per cent, as the S&P 500 Index fell 46.3 per cent over the same time period. Convertible arbitrage (+16.6 per cent), multiple arbitrage (+18.2 per cent) and merger arbitrage (+5.5 per cent) were particularly strong performers during this time period.
The downside protection of hedge funds is also evident when analysing the monthly returns of the Hennessee Hedge Fund Indices versus the S&P 500. In months when the S&P 500 declined in value, hedge funds, on average, participated in less than 30 per cent of the loss. The Hennessee Arbitrage/Event Driven Index was once again the most successful at protecting capital in down markets with an average loss of 0.1 per cent a month versus the S&P 500 Index average loss of 3.9 per cent. The Hennessee Long/Short Equity Index generated an average loss of 0.9 per cent, while the Hennessee Global/Macro Index averaged a loss of 1.0 per cent.
With the numerous head winds that still remain for the economy and financial markets, the Hennessee Group believes it is important for investors to not only revisit their overall allocation to hedge funds, but also think strategically about their underlying hedge fund strategy exposures to identify which are most likely to outperform going forward, particularly in the event of a market-sell-off.
