Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.
Some investment commentators favor the buy and hold approach. A preeminent advocate is Jeremy Siegel, a Wharton professor who is author of Stocks for the Long Run (third ed., 2002). For Siegel, if an investor has a sufficiently distant horizon, then a diversified portfolio of common stocks will likely produce the most satisfactory returns. A good example of the opposite position is Ed Easterling’s Unexpected Returns: Understanding Stock Market Cycles (2005). Easterling argues that high prevailing price/earning ratios (in the 20 times or higher area) imply a coming period of sub-par returns, while P/E’s (say, low double digits or high single digits) predict a period of superior returns. For the investment horizons that matter to most investors, the time of entry and exit into the stock market is critical—unless you are investing in a hedged position. Easterling made the prediction in his book, released in April 2005, that then prevailing P/E's in US stock averages indicated a coming period of disappointing returns. It turned out to be a very good prediction.
I have done some calculations of what would have happened to four sample portfolios invested at the beginning of January, 1999 and left unchanged until the end of September 2008. I don’t claim such a period is typical, only that it happens to be the most recent decade. Such a portfolio includes part of the later run-up of the tech bubble, its subsequent collapse, the events of 9/11, the Fed’s massive injection of liquidity after these events, the era of easy credit, and the still building credit crisis. I will update these numbers for my readers in January of 2009, after ten whole years have passed. I have also calculated adjusted results after inflation, using the federal CPI-U index (geometric average: 3.09% per year for the period). The four portfolios were hypothetically invested $1,000,000 each in one of the following four indices: the S&P 500 Total Return Index (a broad index of 500 major US companies)(taking into account stock price changes, distributions and splits, and dividends), the Lehman Brothers Aggregate Bond (a broad and well-accepted bond index), the HFRX Global Hedge Fund Index (covering a broad spectrum of hedge fund strategies) and the HFRX Equity Long-Short Index (limited specifically to equity long and short strategies)(see www.HedgeFundResearch.com.) Note that the S&P 500 TR Index has fallen much further this month (October 2008), but we arbitrarily closed this analysis at the end of last month to facilitate the cross comparison.
The data is mapped out in the chart below, both in nominal terms and post-inflation.
| Year | S&P 500 | Lehman Agg. Bond | HFRX Global | HFRX Long-Short | CPI* | |
|---|---|---|---|---|---|---|
| 1999 | 21.04% | -0.83% | 26.66% | 41.03% | 2.7% | |
| 2000 | -9.10% | 11.63% | 14.29% | 16.97% | 3.4% | |
| 2001 | -11.89% | 8.42% | 8.67% | 8.96% | 1.6% | |
| 2002 | -22.10% | 10.27% | 4.72% | 2.12% | 2.4% | |
| 2003 | 28.68% | 4.11% | 13.39% | 14.47% | 1.9% | |
| 2004 | 10.88% | 4.34% | 2.69% | 2.18% | 3.3% | |
| 2005 | 4.91% | 2.43% | 2.72% | 4.19% | 3.4% | |
| 2006 | 15.79% | 4.33% | 9.26% | 9.23% | 2.5% | |
| 2007 | 5.49% | 6.97% | 4.23% | 3.21% | 4.1% | |
| 2008 YTD (SEP.) | -19.29% | 0.63% | -11.61% | -13.61% | 4.8% | |
| Cumulative | 11.44% | 65.39% | 98.34% | 117.86% | 34.5% | |
| Annualized | 1.12% | 5.30% | 7.28% | 8.31% | 3.1% | |
| Final value of $1,000,000 | $1,114,413 | $1,658,854 | $1,983,362 | $2,178,586 | ||
| Inflation Adj. Cumulative | -23.03% | 30.92% | 63.87% | 83.39% | ||
| Inflation Adj. Annualized | -1.97% | 2.21% | 4.19% | 5.23% | ||
| Inflation Adj. Final Value | $769,744 | $1,309,184 | $1,638,693 | $1,833,916 | ||
| Inflation Adj. Gain/Loss | -$230,256 | $309,184 | $638,693 | $833,916 |
*Includes estimate for Sept. 2008 of 0.54%. Analysis shows depreciation of initial investment by inflation rate.
Here are summary results:
- The S&P 500 Index portfolio rose by only 11.44%, for an annual return 1.12%, and a final account value of $1,114,413. Inflation-adjusted, the final value was only $850,735, a loss of negative 14.93%, or negative 1.97% per year.
- The bond portfolio rose to a final value of $1,653,854, a cumulative return of 65.39%, or 5.30% per annum. Inflation-adjusted, the final value was $1,390,176, an adjusted total return of 39.02%, or 2.20% per year.
- The HFRX Global Index rose to a final value of $1,983,362, a total return of 98.34%, or 7.28% annualized. Inflation-adjusted, the index returned a final account value of $1,719,684, for a cumulative adjusted return of 71.97%, or 4.19% per year.
- Finally, the HFRX Equity Long-Short Index rose to a final value of $2,178,586, for a total return of 117.86%, or 8.31% annualized. Inflation-adjusted, this gave a final value of $1,914,908, for an adjusted cumulative return of 91.49%, or 5.22% per year.
We can draw these conclusions:
- The two hedge fund indices far outperformed bonds and also the S&P 500 Index. Between bonds and the S&P, bonds did much better.
- Investors in the S&P 500 Index enjoyed only a very modest gain over the period, and an after-inflation loss. These losses have been aggravated by further sharp losses in early October.
- Much of the out-performance by the hedge funds occurred in the earlier years of the decade. Since about the beginning of 2006, the referenced hedge funds strategies in aggregate have outperformed the S&P 500, but by a smaller margin.
- In this retrospective view, hedge fund investors in aggregate had a much better experience than those investors who simply bought the S&P 500 Index. (A distinction is that investors massively buy into equivalents of the S&P 500 Index, through open end mutual funds, ETF’s and total return swaps. Generally, though, investors do not buy into a hedge fund index, as such, although some attempts have been made in recent years to create such synthetic vehicles.)
- Naturally, past performance is no guarantee of future results. There is also some suggestion, if present trends continue, that greater selectivity and analysis may be necessary in identifying hedge fund investment vehicles. As hedge funds have grown larger as a percentage of the total market, the danger of positive correlation with the broader market has increased, even for those funds that actively “hedge.”
Andrew Szabo CFA is Director of Research and Managing Principal at Greenwich Alternative Advisors LLC. He can be reached at 203-622-4923 or by email: aszabo@GreenwichAlternative.com. mailto:ASzabo@GreenwichAlternative.com).
