Maybe Hedge Funds Don’t Stink After All?

The “hedge” in hedge fund finally seems to be working again.

“After several challenging years following the financial crisis, the risk-adjusted performance of hedge funds, measured by sharpe ratio, is improving,” writes Bank of America Merrill Lynch technical analysts Jue Xiong. “As of the end of February 2017, hedge funds delivered sharpe ratio of 3.8 over the trailing 12 months, compared to 1.3 by the S&P 500.”

The BofA note highlighted the fact that distressed credit funds returned 19.5%, event-driven, 13.2%, and convertible arbitrage funds, 10.7%, beating the S&P 500‘s 10.6% from March 31, 2016 to February 1, 2017. Meanwhile stock market neutral funds, long/short funds, macro funds, managed futures, merger arbitrage funds, and dedicated short biased funds fell short.

 Examining the data more closely, it appears that the BofA note compared the total returns of the hedge funds to the price change of the S&P 500. That’s not an apples-to-apples comparison. Over the same time period, the S&P returned 12.6%, which knocks out convertible arbitrage funds’ 10.7% return. It’s also probable that the S&P 500 returns beat event-driven funds’ returns after fees. Lyxor’s Philippe Ferreira likes event-driven funds and finds them “highly attractive.” He explains:

Exposures are balanced between cyclical and defensive sectors (though there has been a tilt toward adding to cyclicals lately), thus preventing any major reversal in market optimism from causing losses on Event-Driven portfolios. CEO confidence is at a decade high which is likely to translate into stronger corporate activity… Fiscal reform, if implemented in the coming months, should be supportive for sectors such as telecommunications or consumer staples (they currently pay a higher effective tax rate than other sectors) that rank high in Event-Driven portfolios. Meanwhile, the newly appointed chairman of the Federal Communications Commission, Ajit Pai has repeatedly called for a light-touch, free market approach to regulation. This is likely to make the environment for Event-Driven managers more predictable and less sensitive to deal breaks.

But how much are investors willing to pay for a big “if”? Based on long-term investing trends, it’s clear that investors won’t pay up for hedge funds that don’t deliver performance and likely won’t rush in to event-driven funds just because fiscal reform could be on the horizon.