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Fig.1 SPY versus equity long/short hedge funds (January 1993 – June 2014)


4 3 2 1 0


-1 -2 -3 -4


Product with low fees: 7.2% p.a. net Product with high fees: 10.9% p.a. net


3.3 2.2 62% 68%


“Compound interest is the eighth natural wonder of the world and the most powerful thing I have ever encountered.” — Albert Einstein


32% 38% -1.9 ETF on S&P 500 (SPY) -3.5 HFRI Equity Hedge Index


SPY, the passive long-only portfolio in this case, compounded at an annual rate of 7.2%, while the portfolio where risk is actively managed compounded at a rate of 10.9%, net of all fees in both cases. Compounding at 7.2% for 21 years turns a $100 investment into a $431 pot. Compounding at 10.9% for 21 years brings $100 to $878. Arguably, this is a big difference. Note that the investment approach with the higher fees compounded at a higher rate on a net-of-fees basis. How is it done?


Fig.2 Underwater perspective – SPY versus equity long/short hedge funds


100 90 80 70 60 50 40 30 20 10 0


Source: IR&M, Bloomberg


10.9% p.a. 7.2% p.a.


SPY HFRI Equity Hedge Index


Asymmetry and positive compounding “The opposite of hedging is speculating.” — Mark Twain


One of the marketing one-liners in hedge funds is that “hedge funds produce equity-like returns on the upside and bond-like returns on the downside.” While this is somewhat tongue-in- cheek, it is not entirely untrue. Hedge funds often underperform during bull markets and outperform in bear markets. The trick for superior long-term compounding of capital is asymmetry. The reason for this is that large losses destroy the rate at which capital compounds. A 50% loss requires a 100% gain to break even. A 20% loss “only” requires a 25%


16


return to break even. This is a big difference. How does this work in practice?


These asymmetries are best explained with an example. Fig.1 compares two investment philosophies: one where risk is actively managed and one where it is not. For the active portfolio, we use a proxy for the average equity long/short hedge fund portfolio, in this case the HFRI Equity Hedge Index, which is an index comprised of equity long/short managers. For the passive portfolio we have chosen the oldest ETF of equities, SPY, which tracks the performance of the S&P 500 Index. SPY was launched in January 1993, which means the observation period covers more than 21 years to June


No asymmetry, no compounding The average performance of the long-only investment when negative is -3.5% per (negative) month on average. The average positive return is 3.3%. In other words, the asymmetry works against the investor; the negative returns are, on average, larger than the positive returns. However, in the case of SPY, there are more positive returns; 62% of returns were positive and 38% negative. In Japan, this relationship is currently around 50% versus 50% and long-term returns are zero or slightly negative. This means that if there is no asymmetry of some sort, there is no positive compounding. In the equity long/short example from above, the average negative return is “only” 1.9%, much less than the average negative return in SPY. Furthermore, the average positive return is 2.2%, i.e., larger than the average negative return. This means the asymmetry works in favour of the investor. Putting it differently, the outperformance when returns are negative is 1.6% (3.5%-1.9%) but the underperformance when positive is 1.1% (3.3%-2.2%). While this looks small, it isn’t; it’s material. Over time, it results in explaining the superior long-term performance of an investment style that includes risk management over one that doesn’t.


Smooth positive compounding of capital requires asymmetries Our claims are simple. First, asymmetric risk/ return profiles are attractive. It means nothing else than having a high probability of financial success and survival with a low probability of the opposite. Second, these profiles are not a function of randomness or market forces but a function of seeking (new) investment opportunities while actively managing risk, whereby risk is defined in


Source: IR&M, Bloomberg


2014. The chart shows the average of the positive returns for the two portfolios as well as the average of the negative returns. The compound annual rate of return (CARR) of the two portfolios is shown in the legend while the frequencies of returns are displayed in the bars.


INDEX AS PERCENTAGE OF PREVIOUS HIGH (%) 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015


AVERAGE MONTHLY RETURN (%)


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