Investors hedging away their return?

It’s hard to make a case that investors are being risk adverse when billions of dollars are pouring into hedge funds.  Hedge funds have historically been associated with high leverage, derivative investments and, on occasion, big blow ups.  But today, most hedge funds are pitching themselves as low risk, steady return investments.  They have become the "safe" alternative for "smart" money. 

However, investment trends that attract too much capital always suffer the same fate…they begin to underperform because the excess return available when the investment opportunity was undiscovered becomes priced away.   I think this is what is occurring with hedge funds.  So much money is being put to work through hedging activities…long/short pair trades, option call writing, hedging with futures…that these techniques are all underperforming the simple strategy of just going long stock. 

Since S&P introduced the Hedge Fund Index in Sept 2002, the index has underperformed the S&P 500 by over 25 percentage points.   The HFI is only up 17% since Sep 2002 while the S&P is up 47%.  Obviously, over the three years prior to 2003, the Hedge Fund Index outperformed the S&P 500 by a similar margin, which explains the popularity of hedge funds right now – perceived safety and lower volatility.  Even during the S&P 500 run since 2002, the HFI was much less volatile.  It has a standard deviation of .18% vs a standard deviation of .5% for the S&P 500.  You can see it in the data lines – the S&P 500 line looks like a cardiac patient vs the steady HFI.   


I think this trend shows two things.  First, investors are not overly exuberant.  They are moving away from more volatile but potentially more rewarding long-only strategies and opting instead for steady but unspectacular returns. 

Sounds like investors want bonds, doesn’t it?  Problem is, 10 year bonds yield under  4.5% right now, which doesn’t even cover the cost of 3% inflation and taxes.  So investors are scrambling to find "bond-like" returns and volatility.    

Second, I think it bodes well for stocks.  I think this stock cycle is fairly "normal"  Most stock movements are making sense – earnings go higher, stocks go higher – earnings go lower, stocks go lower.  While there’s some speculative activity but it is well contained.   In addition, once investors realize they are hedging away most of their return and barely keeping up with inflation, I think they will return to long-only stock strategies which could give stocks an additional boost.   

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