Sleeping Dragons: Hedge Fund Anti-Quality Exposures Persist but Lie Low

Factor Tilts
September 28, 2017

Nine years into a bull market and with volatility at a historical low, now is a good time to ensure you’re on top of the risks in your hedge funds and active equity. In Sleeping Dragons, we take a second look at a hedge fund index and contemplate what might happen when market turbulence returns.

The risk-loving quest for outperformance can give hedge funds an anti-quality profile: one with too much volatility and leverage and too little profitability relative to a diversified benchmark. Left unchecked, these exposures can drive performance, and in our empirical study " Are Hedge Funds Anti-Quality?," we found that they did. Our study focused on a hedge fund index exchange-traded fund (ETF), the Global X Guru™ Index ETF (GURU). From its website, GURU "seeks to generate alpha over the broad market by investing in highest conviction ideas from a pool of hedge funds." GURU’s holdings are based on these hedge funds’ long-only equity positions in US companies, which are obtained from their Securities and Exchange Commission Form 13F filings.

GURU exhibited a disturbingly consistent anti-quality profile relative to the Russell 3000 Index over the nearly four-and-a-half-year period beginning in July 2012 and ending in October 2016. The anti-quality profile contributed materially to GURU’s outperformance of the Russell 3000 during an initial period of almost three years, and to its underperformance in the subsequent year and a half during which GURU crashed twice.

Since the completion of our study in October 2016, the US equity market has grown by more than 15% and volatility has hardly been noticeable. Historically, this market climate has been relatively favorable for hedge funds, and GURU outperformed the market by 31 basis points from November 2016 through June 2017 as shown in Figure 1.

Cumulative active returns to GURU

Figure 1: Cumulative active returns to GURU (net asset value) over the Russell 3000 Index, November 2016–June 2017. Source: Bloomberg Finance L.P. and the FTSE Russell website.*

An analysis based on a GURU replication indicates that the anti-quality profile has persisted. Table 1 shows that anti-quality contributed 49 basis points of outperformance between November 2016 and June 2017. The most substantial anti-quality contribution came from the outperformance of high-beta stocks.

Quality factor exposures and return contributions

Table 1: Quality factor exposures and return contributions to a GURU replication relative to the Russell 3000 index, November 2016–June 2017. Source: Bloomberg Finance L.P. and Barra US Total Market Equity Model (USSLOW).

Equity markets are calm just now, and market disruptions may seem like a distant, unpleasant memory. But turbulence will inevitably return, even if we cannot say when. If quality continues to be a winner in troubled markets, investors in hedge funds with anti-quality profiles may, once again, wonder what they are getting for fees as high as 2 and 20. Investors with complex and opaque holdings might consider factor profiling their investments before the next drawdown, giving themselves the opportunity to put the hedge back in hedge funds.

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* "FTSE Russell" is a trading name of FTSE International Limited (FTSE) and Frank Russell Company (Russell) and their respective subsidiary undertakings, which are members of the London Stock Exchange Group plc.
The Russell 3000® Index is an equity benchmark for US stock performance. It is a capitalization-weighted index covering the largest 3,000 publicly traded US stocks. The index represents approximately 98% of the total market capitalization of the US stock market.
Aperio’s strategies are not in any way connected to or sponsored, endorsed, sold, or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). All rights in the Russell indexes vest in the relevant LSE Group company. The LSE Group does not accept any liability whatsoever to any person arising out of the use of the strategies or the underlying data.

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