A bunch of people on LinkedIn were saying how hedge funds UNDERPERFORMED the S&P (+24%) but we will explain below why that is the WRONG conclusion to draw.
First, you need to understand that most hedge funds are measured by their ability to deliver ALPHA, or uncorrelated returns to the market.
For those who took math class, a fund's performance (y) can be broken down into y = a + bx where x is the market (S&P500) returns. Hedge funds are expected to produce uncorrelated returns to the market, so b is close to 0. That leaves the constant term a, which is the "alpha".
They achieve uncorrelated returns by being market (and factor) neutral and trading a lot (more independent outcomes + law of large numbers). Consider a L/S HF. They'll always long the top in a basket of factors and short the bottom, which reduces them from systemic market risk.
Now, long-only funds do exist and a lot of those funds mentioned are predominantly LO funds (or do some VC) like Tiger, Coatue, D1, Whale Rock, and Lone Pine. Explains why they all got wrecked in 2022 alongside the market, since their beta term is positive and large.
However, the multistrats and quant funds (arguably the cream of the crop these days) truly deliver uncorrelated alpha. RenTech, AQR, Millenium, Citadel, DE Shaw, P72, Balyasny, Brevan Howard, etc. There's a reason why their returns are consistently positive. Just look at 2022.
These guys care about something called risk-adjusted returns and minimizing drawdowns, best measured by their sharpe ratio. Sharpe ratio is just returns divided by std. dev. of those returns. If your sharpe is high, it means you consistently make money and have low drawdowns.
When you have high sharpe and low drawdowns, that means you can lever up. That's why you hear crazy stories about how quant funds and multi-managers are leveraged 10+ times.
What isn't obvious is that same principle of leverage applies to the investors of those funds. If I get to personally invest in Citadel, you better bet I'm going to lever up. I know they're consistent with low drawdowns so there's lower chance of my collateral getting wiped out.
That's the whole point. The hedge funds want to let their investors decide how much risk they want. Higher risk profile --> higher leverage/allocations --> higher returns. We call this volatility targeting.
The hedge fund is targeting a very low volatility (typically 2.5-5%). Investors know this before investing in the fund. This way, if they want 10% volatility (same as the S&P), they would just apply enough leverage to get that.
If I'm a pension fund I probably want more stability because of my annual payouts, so I'll target a lower volatility. If I'm a sovereign wealth fund with a longer time horizon, I'll target higher volatility to juice my returns.
So hypothetically, if Citadel is targeting 5% vols and still returned 15.3% this year, then they achieved 3 sharpe. If I levered 2x in them to match the index's vol, I would get 30.3% returns this year, which is better than the S&P.
What's even better is Citadel's returns are entirely ALPHA, so it's unlikely to correlate with any of my other investments. That means I could've allocated whatever amount I was comfortable with in the index to get market returns while diversifying the rest in Citadel.
Uncorrelated means they aren't going to draw down at the same time. In fact, uncorrelated alpha can be thought of as a positive buffer, so even if the markets blow up like in 2022, I know my portion in Citadel is still going to be positive, hedging my losses from the index.
For those out there with a bit more experience with portfolio combination, you know the effects of combining uncorrelated (or negative correlated) strategies. Take an equal-weighted portfolio for example.
The expected return is the mean of each strategies' expected return while the variance is the mean variance scaled by a factor of 1/N (where N is number of strategies). There's also 2 * covariance terms but if strategies are uncorrelated (or even negative), that number is <= 0.
The result is reduced variance and thereby higher sharpe. This allows you to use leverage to target your ideal volatility. Institutions can borrow at close to the risk-free rate. Just think about how much they can juice returns if their portfolio has high sharpe.
I used the term leverage loosely here. In practice, institutional investors have massive capital and they too have their own vol targets. Some of them are certainly using leverage but others may just be overweighting their portfolio in high sharpe hedge funds (similar effect).
To summarize, most hedge funds deliver alpha and have low volatility targets. This allows their investors to increase allocation, effectively levering up to whatever their own vol targets are, and since returns are uncorrelated, boost the sharpe of their entire portfolio.
