Stock-picking doesn't work

This chart is revealing. It shows the performance of one class of hedge funds, according to Hedge Fund Research.
Which class? Not macro. Not distressed securities. It's equity market neutral. Yes, neutral. Such funds, in theory, should take short positions to, well, neutralize stock market exposure.
But when they most needed neutral exposure, they didn't have it. Between July 3 and last Friday, neutral funds lost nearly as much as MSCI's world equity index - 5.7% against 7.8%.
One reason for this, as Eric says, is that changing correlations and volatilities screw up the calculations behind stat arb trades.
Another reason, I suspect, is that the turnaround in markets has hit momentum investing hard, as the stocks that benefited from high liquidity (such as commodity stocks and takeover targets) have lost from its withdrawal.
Another feature of the chart is just how low the returns are to neutral funds even over the longer-term. In the four years to early July (the peak), this index returned barely 12% - less than UK cash.
As hedge fund indices are probably not  downwardly biased measures of return, this is pretty feeble. Even if the stock market is irrational, it doesn't follow that you can easily out-perform it.

Comments

[Luis Enrique]

Is your headline fair? Aren't market neutral funds based on the sort of rules-based portfolio selection that are the antithesis of stock picking? And, come to think of it, closer in spirit at least to the approach to investing I'd expect you to advocate?

I don't know how market neutral funds are constructed - I can understand how changing correlations screw up portfolios based on historic stock behavior, so is that what nominally market neutral fund do, give high weights to stocks that historically have been negatively correlated with the market?

[Matthew]

I think you're confusing a market-neutral fund, which as Chris says aims to use short positions to benefit when the market is losing, as well as long so they benefit when it is gaining (if it sounds too good to be true, then as the chart shows it is, but IIRC they only aim to slightly beat T-Bills), with a passive fund, which merely mimics the market exactly (hopefully).

[Luis Enrique]

I think I have misunderstood how market neutral funds work, but I haven't confused them with passive (tracker) funds.

Market neutral funds do not aim to benefit when the market is losing - that's just being short the market. To try and be market neutral (remove market risk) you must have to mix longs and shorts, but you cannot just match longs with shorts otherwise you'd just constantly lose trading costs (a bit like betting on every horse in the race) so I imagine market neutral portfolios must have to be constructed putting different weights on long and short positions based on past correlations.

Aha, that's where I've gone wrong -
I was confusing market neutral funds with risk minimization - as in the portfolio Mr Dillow occasionally puts together for his IC readers. The stock picking must comes in because first you pick the stocks that you think are going to give you 'alpha' and try to remove market risk by taking out complementary positions in other stocks. So it is stock picking, and the headline isn't unfair at all.

Although if I've now understood market neutral funds correctly, then the fund should only deliver returns equal to the portofolio's alpha (I'm probably using the wrong word - I mean the extent to which the stocks outperform the market)
in which case being down 5.7 when the market's down 7.8 isn't too shabby is it?

[dearieme]

An index-linked savings certificate will protect you from inflation (RPI based) while also protecting you from disinflation; its value won't sink if inflation turns negative and it'll still pay you some interest. Amazingly - or perhaps not - I don't think I've ever seen charts or tables comparing the performance of other investments with the performance of this untaxed device.

[pommygranate]

Chris

Astute observations.

I used to work as a money manager at a 'market neutral' hedge fund. A couple of points;

i) we (those of us that worked in Hedge Fund Alley - about a square mile based around Curzon St) were all long and short the same stocks. I know this because we all talked - regularly.

ii) our performance closely tracked the Index minus our fees. This doesn't make intuitive sense but happens to be true.

iii) Hedge Funds are fee-generation vehicles with a smaller but associated asset management business.

iv) There are so many HF managers these days that any genuine arbitrage that once existed in the good old days (pre-2003) is long gone.

v) The ultimate fee generation machine is a 'fund of funds' - think of them as fees to the power n linked to performance of a Treasury note.