The Dutch-based trend follower Transtrend offers insights into “benchmarks”:
Benchmarks problem: “Hedge funds” are not an asset class because different hedge fund strategies are fundamentally different in their:
- Source of return.
- Shape of distribution of returns.
- Correlation structure with traditional asset classes.
Also keep in mind:
- Hedge fund styles can differ even more from each other than traditional asset classes can.
- A benchmark is only meaningful if it acts as a proper description of an investment strategy (such as ‘Equity long only’ or ‘Trend following CTAs’).
- Benchmarking does not excuse the investor for not understanding the investment.
Why the Benchmark Problem Matters for Trend Following Investors
Transtrend’s three-point framework for why “hedge funds” fail as an asset class is the clearest available statement of the categorical error that institutional investors routinely make when evaluating systematic trend following managers. The error is treating all hedge fund strategies as variations on a theme rather than as fundamentally different approaches with different risk/return profiles, different behavioral characteristics during market stress, and different relationships to the traditional asset classes that make up most institutional portfolios.
The source of return distinction is the most important. A long/short equity hedge fund generates returns by identifying mispricings in equity valuations — overvalued stocks to short, undervalued stocks to buy long. The source of return is stock selection skill. A systematic trend following CTA generates returns by following sustained price trends across global futures markets. The source of return is the behavioral tendency of markets to trend, driven by the same crowd psychology and policy persistence that Keynes, Livermore, and Henry all observed independently. These are not variations on a theme. They are categorically different mechanisms that will perform differently in the same market environments.
The shape of distribution of returns makes the same point statistically. Long/short equity funds tend to produce returns with approximately normal distributions — frequent small wins and losses, rare large outliers. Systematic trend following produces positively skewed returns — frequent small losses, occasional large wins. A benchmark that averages across these two types of funds produces a blended distribution that describes neither. An investor who uses a hedge fund index as a benchmark for their trend following allocation is comparing their results to something that is 50% a different strategy. The comparison is meaningless for evaluating whether the trend following allocation is performing as it should.
The correlation structure point is what makes the benchmark error costly rather than merely misleading. Systematic trend following has low or negative correlation to equity markets, specifically during the equity market crises that produce the largest equity losses. This is the primary reason institutional investors allocate to trend following: it diversifies the equity risk that dominates most institutional portfolios. A hedge fund index that includes long/short equity strategies will have higher correlation to equities than a pure trend following allocation. Benchmarking a trend following allocation against this index obscures the diversification benefit that is the primary reason for the allocation.
Transtrend’s third point — that benchmarking does not excuse the investor from understanding the investment — is the most important for individual investors. The impulse to benchmark is the impulse to evaluate performance without the cognitive effort of understanding what the strategy does and why. Benchmarking a trend following fund against a hedge fund index and concluding it underperformed is not investment evaluation. It is the application of an inappropriate standard that produces a misleading answer. Understanding the investment requires understanding its source of return, its expected return distribution, and its correlation structure. Only with that understanding can an investor evaluate whether the allocation is performing as it should across the market environments it is actually designed for.
Frequently Asked Questions
Why are hedge funds not an asset class?
Because strategies grouped under the “hedge fund” label have fundamentally different sources of return, different return distribution shapes, and different correlations to traditional asset classes. A long/short equity fund and a systematic trend following CTA are no more similar as investments than equities and bonds are — they just happen to share a fee structure and a regulatory exemption. Treating them as an asset class and benchmarking one against an index of the other produces meaningless comparisons.
What is the correct benchmark for a systematic trend following CTA?
An index of systematic trend following CTAs with similar time horizons and market exposures, such as the SocGen CTA Index or the Barclay CTA Index filtered for systematic trend followers. These benchmarks describe the same investment strategy, have the same source of return, similar return distribution shapes, and similar correlation structures. Comparing a trend following CTA to these benchmarks produces meaningful information about whether the specific manager is performing better or worse than peers using the same approach.
What does Transtrend mean that benchmarking does not excuse not understanding the investment?
That evaluating performance requires understanding what performance should look like for the specific strategy, not just comparing a number to an index. A trend following fund in a flat, non-trending market year might underperform an equity benchmark while performing exactly as it should given market conditions. An investor who does not understand that trend following underperforms in flat markets cannot evaluate whether the underperformance is a sign of manager failure or normal strategy behavior. The benchmark comparison without strategy understanding produces incorrect conclusions.
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