Index-Huggers on Notice

Investors are increasingly insistent that active managers, hedge funds among them, generate gains that do not track the market. To get capital, managers have to demonstrate their ability to make non-correlated returns. “Performance is disguised beta unless the manager can show me otherwise,” says an executive from a corporate pension plan, quoted in a survey of institutions and hedge funds by Citi Prime Finance.

But judging from past performance, certain hedge fund strategies are strongly related to the underlying market. In particular, long/short equity tends to be highly correlated  to the stock market. The reason is that most managers are long much more than they are short. This made sense during the last half of the 20th century, when the stock market on the whole went up.

By contrast the early 21st century so far has been more like the first half of the previous century. The Dow Jones Industrial Average did not recover from the 1929 crash until the 1950s. Today the Dow closed about 1,000 points higher than the bubble peak 12 years ago, but it look shaky. No wonder investors look for hedge funds capable of going beyond market indexes.

“I hate the term ‘hedge fund’. They are really index-agnostic money managers that have money invested alongside,” says a  public pension plan official in the Citi survey. “We’re trying to differentiate between index-hugging and non-index-hugging managers.”

The search is for “non-index-hugging” funds. That’s a mouthful, but still easier said than done. Unlike the go-go years before the crisis, the onus is really on the managers. And it looks like that will not change in the foreseeable future.

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