Discretionary-Based Hedge Funds Outperform Systematic-Based Strategies Over the Long-Term - May 2014

by Boris Friedman

  • 28 May 2014
  • HF

One of the big topics of debate in the hedge fund industry is which style of trading is best – systematic or discretionary? Hedge fund managers who approach their investment decisions based on a systematic strategy use technical algorithmic models that utilize vigorous statistical and historical analysis. At the opposite end of the spectrum, discretionary-based hedge fund managers use their own subjective judgement and analysis when making a trade based on their knowledge of financial and capital markets. It is sometimes argued that systematic strategies are advantageous in that there is no human emotion involved when making trades, thus reducing the chance that a manager would make an irrational decision during times of instability in financial markets.

Preqin’s Hedge Fund Analyst tracks the performance of both discretionary and systematic hedge funds. Preqin’s benchmarks show that, on average, discretionary funds have delivered superior returns compared to systematic funds over recent years. As of April 2014, discretionary funds have moderately outperformed systematic funds in the year-to-date, posting cumulative returns of 1.71% compared to 0.64%. More interesting are the longer term benchmarks; for the 12-month period ending 30 April 2014, discretionary funds returned 11.18% while systematic funds lagged behind with average returns of 4.55%. Three-year returns also show discretionary funds performing better than systematic funds, with annualized returns of 7.53% compared to 4.43%.

Although one might conclude from this recent performance that a discretionary fund would be the better investment option, it is important to note what happened to these two trading strategies during the financial crisis of 2008. In 2008, discretionary funds performed poorly, attaining a benchmark average net loss of 18.46%. Systematic funds also suffered but the average loss was marginal at -0.03%. This glaring contrast in performance in 2008 could be explained by the fact that trades in a systematic fund are controlled by software algorithms and are not subject to the interference of human emotions during periods of unstable capital markets. Hence, it can be said that systematic-based strategies are advantageous as they are less volatile in times of financial instability. Indeed, the returns of discretionary funds over the last three years displayed a volatility of 6.10%, while systematic funds were half as volatile at 3.05%. Therefore, it can be said that systematic funds perhaps represent a more attractive investment solution for risk-averse investors.

It is notable that not all hedge fund strategies have followed this pattern of discretionary trading outperforming a systematic approach. For example, discretionary and systematic relative value funds have posted similar returns recently (6.11% against 5.38% over the past 12 months) and over the longer term (5.50% against 6.64% annualized over the past three years), while also maintaining volatility levels of 3% or less. In terms of funds following macro strategies, systematic funds have generally performed better than discretionary vehicles over the past few years. For instance, in the 12 months to April 2014, systematic macro funds gained 2.61% while discretionary funds were in the red with a loss of 0.24%. Systematic funds have also generated higher returns than discretionary funds in this strategy over the last three years; however, in contrast to most other strategies, the volatility of returns is lower for discretionary funds than systematic funds (2.69% versus 3.28% over the last three years).

Discretionary strategies have generally outperformed systematic strategies in recent years, but whether discretionary funds are the better investment option depends heavily on both the preferred underlying strategy and wider market conditions.

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