Hennessee Group LLC, an adviser to hedge fund investors, found in a brief study that directional hedge fund strategies were the primary drivers of portfolio performance in 2010, most notably event driven, distressed and emerging markets (ranking one, two and three, respectively among the Hennessee Hedge Fund Indices).

The under-weighting of these strategies in a hedge fund portfolio likely resulted in under-performance against major hedge fund indices. Charles Gradante, Co-Founder of the Hennessee Group stated, “2010 was a tough year for non-directional hedge funds. The market rally that commenced in early 2009 and continued through the end of 2010 benefited those strategies with elevated levels of exposure to the financial markets as they were able to benefit from the beta tailwind across most asset classes.” Gradante added, “At the multi-manager level, portfolios that lacked exposure to directional strategies struggled to keep up with the broader Hennessee Hedge Fund Index. That said, investors should be aware that while directional strategies may offer greater upside potential, they also come with greater downside risk.”

Top Three Performing Strategies in 2010

Characteristics of Directional Strategies

Directional strategies such as event driven, distressed and emerging markets strategies tend to be more long biased to the markets and utilize less hedging. Heightened exposure levels to the markets leads to higher correlation to the broader markets and more systematic (beta) risk. Increased directional risk allowed them to perform well on a relative basis during the recent market rallies in 2009 and 2010 as most asset classes experienced broad based gains. Gradante added, “a major challenge for many funds during the recent equity market rally has been the increased correlation and lack of dispersion among individual securities. In 2010, shorting was particularly challenging and served as a significant detractor for many funds in 2010.” Gradante continued, “However, such an environment proved beneficial for funds with increased market exposures as their hedges did not serve as much of a drag on performance as it did for more market neutral funds and other strategies with significant hedges.” (See white paper: Hedge Funds Struggle with New Market Order).

Higher Reward Can Lead to Higher Risk

Directional strategies can offer greater return upside, however this generally leads to greater risk to the downside. As can be seen in the below chart, all three strategies have outperformed the broadly diversified Hennessee Hedge Fund Index over the most recent 10 year period, but have assumed more volatility, particularly the Hennessee Emerging Markets Index. Gradante added, “The 2008 market correction illustrates the risks inherent in more directional strategies.” Gradante continued, “The Emerging Markets Index sold off -30.47% (ranked 23rd), the Distressed Index fell -29.27% (ranked 22nd) and the Event Driven Index dropped off -24.72% (ranked 19th).”

Conclusion

While the Hennessee Group believes there is a place for more directional strategies within a well diversified hedge fund portfolio, it is important that investors are aware of both the upside, as witnessed during the most recent market rally, but also the downside risks.

Charles Gradanteconcluded, “A directional strategy is most appropriate for investors willing to take some risk in exchange for potentially higher returns.  That said, we believe these strategies should be sized appropriately and combined with a mix of non-directional strategies that can offset some of the downside risk during times of market distress.”