Fundamental Value Funds: What Drives Their Performance?

Mar 20 2014 | 9:27am ET

By Megan Woods
Director, MPI

The HFRI Equity Hedge Index gained 14% in 2013. At the beginning of last year that may have sounded great. Next to the S&P 500’s total return of 32% for the year, not so much. 

Here we analyze the performance of one of the larger, better performing sub-categories of the Equity Hedge broad category, Fundamental Value (with a North American Focus). Using Dynamic Style Analysis and a select group of factors we estimate what the main performance drivers are for the category as a whole and why those who excelled or lagged did so.   

Performance in 2013 ranged from -13% to 71%, indicating a large dispersion in how managers implement this strategy.  The top 5% of funds averaged a return of 62% while the bottom 5% averaged a return (loss) of -3%.  The remainder of the funds in the category produced an average return of 22%

When individual exposures are aggregated, the group as a whole will often tell a fairly consistent story. On average, Fundamental Value Long/Short hedge funds display a little over 60% net market exposure over the course of the year. The majority of this is in large cap stocks, followed by small cap stocks. 

When we view the dynamics of these exposures, we observe a decrease in large cap equity exposure over the course of the year, as well as positive exposures to both government bonds and gold, suggesting a more conservative stance at the end of the year, even as equity markets continued to outpace most expectations.

The large cap exposure can be partitioned into sector exposures, and indicates that the highest long exposures in this category were to financials, industrials and health care, with short exposures to consumer staples and telecom—showing a tendency towards long cyclical industries and short or underweight exposure to defensive securities.

As could be expected, the biggest drivers of fund returns tended to be the largest long equity exposures, in particular financials, industrials, health care and small cap stocks. The detractors were the negative exposure to consumer staples, followed by the small long exposure to gold. 

The top 5% of funds show a distinctly different average allocation. While the major exposure is again to large cap equities, net equity exposure is estimated at nearly double the universe average, just over 110%. The short exposure to government bonds may not indicate literal shorting of these securities but rather can indicate leverage, optionality or additional volatility in these funds.

The bottom 5% of funds also differs significantly from the average. While again, large cap equities are the largest equity exposure, net equity exposure estimates are very low at approximately 20%, and with a large long exposure to government bonds.  

Summary:

  • On average, Fundamental Equity Value funds had a net equity exposure of approximately 60% in 2013.
  • This exposure decreased over the course of the year, and on average funds ended the year appearing more conservative than at the start.
  • Average performance of 22% is consistent with the exposure estimates.
  • Top performing funds had a much higher market exposure, however their average returns are in excess of what could be might be expected from the exposure estimates.
  • Bottom funds had a much lower market exposure, and with average returns lower than what might be expected from the exposure estimates.

Megan Woods is currently a Director at MPI, and joined the company in 2003 after receiving an MBA in Finance from UNC Chapel Hill. She has been a CFA charter holder since 2006, and earned an MA in Economics from NYU in 2009. Ms. Woods is currently part of MPI’s fund analysis, research and software development teams. She is also a regular contributor to MPI’s research blog and case studies, and previously served in key roles focused on client services and training.


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