How Hedge Funds Almost Pared Losses amid COVID-19 Turmoil

Using the Calmar ratio, we determine which hedge fund strategies best mitigated equity market drawdowns in H1

This year has proved quite a ride for risk assets, and hedge funds have not escaped the market turmoil. The outbreak of COVID-19 sent the MSCI AC World Index tumbling to a Q1 2020 loss of 33.9%. That said, it had recouped a majority of the loss by the end of H1 2020, when it was down only 7.1%. Overall, hedge funds have lived up to their primary attraction and successfully reduced correlation with the broader equity market: median drawdowns were only -12.6% and median H1 performance almost pared losses, at -1.4%.

Which hedge fund strategies have best mitigated the effects of the market drawdown? To find out, we used the Calmar ratio across several strategy groups. The ratio compares historical median three-year annualized returns for each strategy with the median maximum drawdown during that period. A higher ratio indicates a higher risk-adjusted return.

Relative Value Strategies Provided Best Risk-Adjusted Returns
For some managers, market timing has been more of a challenge as markets become increasingly disconnected from fundamentals. For relative value strategies, however, which exploit market divergences without having to make directional bets, this may have proved advantageous. The long/short nature of these trades can result in an inherent lack of net market exposure, appearing to limit drawdowns over the period and producing the highest risk-adjusted returns of all top-level strategies. With a Calmar ratio of 0.60, as shown in the chart above, these strategies have successfully mitigated downside risk in relation to the returns they have been able to generate. 

Ample Trading Opportunities for Macro Funds 
Macro strategies fared relatively well through the COVID-19-induced fallout, posting a +0.1% median gain in H1 2020. Indeed, market volatility provided ample trading opportunities for macro funds: the Fed’s powerful monetary policy response was a key catalyst in recent DXY weakness, evoking volatility in FX markets and giving rise to precious metals. 

Bearish dollar sentiment prompted hedge funds to become net short USD in May 2020 for the first time since 2018, according to CFTC data. This has since proved a profitable trade when stacked against a long EUR or AUD. Macro funds’ ability to trade in multiple asset classes beyond equities helped mitigate risk, aiding higher risk-adjusted performance as evidenced by its Calmar of 0.42. But this was little comfort to investors at the height of the market panic, when asset class correlations spiked considerably.

Event Driven Strategies Dragged Down by Muted M&A Activity
Event driven strategies posted the industry’s lowest median H1 2020 return at -5.91%. These strategies depend heavily on the trading opportunities provided by corporate M&A and special situations, and such deals have been relatively scarce this year. In fact, according to Refinitiv, both the size and number of M&As have declined to their lowest levels since 2016.

This demonstrates the tail risks of such trades – large losses can occur if M&A deals unexpectedly fall through. That said, the long/short nature of these trades can also limit net market risk exposure and may explain why average drawdowns for event driven strategies were less severe than in the broader equity market. Despite this, weaker returns for these strategies over the past three years led to the worst risk-adjusted performance under the Calmar measure, with a ratio of 0.15 compared to 0.12 for the MSCI AC World Index.

Small Cap Poised for Risk-Adjusted Gains
Looking ahead, equity strategies that maintain a net-long exposure to small caps may have room to gain over the latter half of this year. Small caps’ higher exposure to improving domestic economic fundamentals and lower exposure to global trade risks should prompt outperformance. Indeed, the US economy, home to the highest concentration of public small cap companies, has shown improving productivity and employment data to kickstart returns. Managers will also no doubt have a rich selection of long and short trading ideas as longer-term winners and losers from the pandemic emerge. 

In the broader market, volatility will continue for as long as the future health of the global population, businesses, and economies remains uncertain. And with the US presidential election on the horizon, this could escalate even further. The figures from H1 demonstrate, though, that hedge funds can step up to provide higher risk-adjusted returns than public equity markets, and when investors need it most.

Read the full breakdown of the latest hedge fund returns in our Hedge Fund Performance Update: July 2020.