What is the optimal market exposure for a portfolio of hedge funds? The answer to this question directly depends on an investor’s risk appetite and the role the hedge fund portfolio should play within their broader allocation. Yet, it is important to understand the trade-offs between low and high beta strategies. At Resonanz, we classify the universe of hedge funds into three distinct categories: Convergence, Divergence, and Long-Biased. While Convergence and Divergence strategies are usually characterized by a relatively low equity market beta over a long horizon, Long-Biased strategies are fundamental hedge fund strategies that generally have higher market exposure. However, the universe of funds still varies significantly in terms of their market exposure. This naturally raises the question of whether these strategies inherently have an optimal market exposure that investors should focus on.

In this post, we demonstrate that the Long-Biased strategies exhibit a notable heterogeneity. The Long-Biased hedge fund strategies can be further divided into Equity Hedge strategies and Event Driven strategies. Equity Hedge strategies show a large cross-sectional dispersion in equity beta, and individual funds tend to manage their beta consistently over time. In contrast, Event-Driven managers display less cross-sectional dispersion in equity beta but exhibit higher time series variation for individual funds.

When identifying an optimal range for these groups of managers, we observe that the equity alpha of Equity Hedge managers decreases as their equity beta increases. This leads us to note that Equity Hedge managers with betas around 0.15-0.25 outperform their counterparts, who have betas up to 0.65, in terms of absolute returns.

The analysis presents a different perspective when considering Event Driven managers. Most of these managers lean towards a lower beta implementation. However, we couldn't discern a significant pattern of outperformance or underperformance over time for this group.

In conclusion, we recommend investors adopt a less directional approach when implementing Equity Hedge strategies. Strategies with betas greater than 0.3 appear difficult to justify. Yet, if an investor is inclined towards some long market directionality, we suggest achieving this through an Event Driven allocation. It's important to note, however, that the space for high beta Event Driven managers is consistently smaller than that of high beta Equity Hedge managers.


The Long-Biased Hedge Fund Universe

Utilizing the resources of Resonanz Capital's semi-proprietary database, we collect data on both Equity Hedge and Event Driven funds. Our analysis encompasses a total of 2,662 distinct funds, broken down into 2,189 Equity Hedge and 473 Event Driven funds.

It's important to note that while our assessment is comprehensive, it is not immune to certain known biases (e.g., self-selection of survivorship bias). That said, when conducting a cross-sectional comparison between different fund categories, the inherent biases within each category are likely to offset each other, ensuring that the comparative analysis remains robust and meaningful.


Equity Beta amongst Long-Biased strategies

To grasp a holistic understanding of both the time series and cross-sectional dispersion of equity beta within Equity Hedge and Event Driven funds, we calculate a rolling 3-year equity beta, benchmarked against the MSCI World Net Index, for each fund. We plot this data to capture variations across the 5%, 10%, 25%, 50%, 75%, 90%, and 95% percentiles of beta.

In the realm of Equity Hedge funds, several observations can be made from the chart above. Around 25% of all Equity Hedge funds carry a beta exceeding 1, with the 75% quantile converging near this mark. Additionally, the cross-sectional distribution of these funds offers a relatively stable beta profile. This stability is most evident for funds in the median beta range, which show little time-series variation. However, it's worth noting that the 90% and 95% quantiles, which represent funds with a substantially higher beta, exhibit the most pronounced volatility in beta. Consequently, Equity Hedge managers, particularly those whose beta oscillates between 0 and 1, maintain a stable beta profile over time. It's also noteworthy to mention that the managers with a less pronounced directional strategies showcase closer proximity in terms of beta as compared to those with a higher beta.

Turning our attention to Event Driven funds in comparison to Equity Hedge managers, the distinctions are clear. Primarily, the equity beta for Event Driven funds is discernibly lower. Only a small segment, approximately 10% of these funds, exhibit a beta over 1 – a marked contrast to the 25% observed for Equity Hedge. The distribution of equity beta for Event Driven funds also manifests a right-skew, with the lower percentiles clustering more closely. Moreover, the beta volatility of most percentiles for Event Driven funds outpaces that of their Equity Hedge counterparts. A striking illustration of this is the pronounced surge in beta post the COVID-19 disruption in March 2020. This trend insinuates that Event Driven funds tend to exercise less rigorous management of their equity beta in comparison to Equity Hedge managers.


Equity Beta vs Alpha

When exploring fund returns with an emphasis on equity risk, it's possible to segment a fund's return into two components. The first is tied to its exposure to equity markets, termed as beta, and the second is an unexplainable factor referred to as alpha. Notably, a heightened alpha is indicative of superior performance, as it denotes returns generated independently of equity risk.

To glean insights into the optimal equity beta exposure for Equity Hedge and Event Driven funds, we run a full sample OLS regression for each fund to pinpoint its respective beta and alpha. We then group these observations based on beta, and average annualized alpha.

The resultant data for Equity Hedge funds unveils a notable trend: average alpha tends to decrease with equity beta. This suggests that most managers with high beta owe their performance primarily to the co-movement with equity markets. Drawing further implications from this pattern, it's evident that when portfolios are adjusted for beta, those helmed by low beta managers tend to outperform their high beta counterparts - a pattern also reported in the academic literature on single stocks by Frazzini and Pedersen (2014) 

Contrastingly, the landscape for Event Driven funds diverges from the Equity Hedge narrative. Here, alpha's distribution appears more uniform across varying beta classifications. The singular aberration in this uniformity emerges in the beta range of 0.7 to 0.9. Yet, it is important to note that these results are entirely backward looking. We will thus focus on the investment merits next.


Is there an optimal Beta?

To better grasp the investment implications of this observation, we devise a straightforward investment strategy using a portfolio sort. At the start of each month, we divide our universe of Equity Hedge and Event Driven funds into five distinct portfolios, categorizing the funds based on their 3-year rolling equity beta. Specifically, our first portfolio is composed exclusively of funds falling below the 20% quantile of the cross-sectional beta distribution, while our fifth portfolio includes only those managers with a beta surpassing the 80% quantile. We then allocate equal weights to all funds within a given portfolio and rebalance monthly. The subsequent chart illustrates the cumulative performance of these portfolios.

Several important observations on Equity Hedge funds emerge upon examining the chart above. Notably, at any given moment, Portfolio 1 (representing low beta managers, approx. 0.15) consistently outperformed Portfolio 2 (medium-low beta managers, approx. 0.45). By the conclusion of the sample period, Portfolio 1 (low beta managers) closely aligns with Portfolio 3(medium beta managers, approx. 0.65), albeit with notably reduced volatility. From this, we can infer that, when prioritizing absolute return, investors would be well-advised to favor low beta managers over both medium-low and medium beta managers. Only portfolios 4 and 5 exhibited superior absolute returns by the end of our sample period. This pronounced outperformance can largely be traced back to the marked recovery following the COVID-19 downturn in March 2020. Prior to that, the performance trajectories of Portfolio 3 (medium beta, approx. 0.65), Portfolio 4 (medium high beta, approx. 0.85), and Portfolio 5 (very high beta, approx. 1.2) were strikingly parallel. It's noteworthy that managers with a beta of approximately 0.6 were able to mirror the performance of those possessing nearly double the equity beta during a pronounced bull market phase. Conversely, analyzing Event Driven funds reveals that portfolios 2, 3, and 4 have posted similar performances. However, portfolio 5 has distinctly led the group in performance, whereas portfolio 1 lagged marginally behind.

The observation for Equity Hedge managers indicates better alpha generation for managers with a 0.65 beta compared to those with higher beta values. To further analyze this aspect, we calculated the 3-year rolling monthly alpha for our portfolios, as displayed in the chart below:

Two observations are worth highlighting for Equity Hedge funds. First, low beta managers generated the highest and most consistent alpha over almost the entire sample period. Second, the higher the beta, the more volatile the alpha. Moreover, as expected, the two highest beta portfolios largely displayed the lowest alpha. Even more strikingly, the alpha of portfolio 5 was negative over an extended period. This suggests that, when considering only absolute returns, an investor would have been better off with a 1.2 levered position in an ETF than investing in that hedge fund group, all the while paying significantly lower fees and not being constrained by any redemption terms.

In conclusion, we recommend that investors should primarily invest in low beta Equity Hedge funds, as they either directly outperformed their higher beta counterparts on an absolute return basis, or those with higher absolute returns did not manage to outperform much cheaper, and more liquid, investment solutions with the same risk-return profile.

When examining Event Driven funds, we find no clear patterns. Notably, high beta funds realized significantly higher alpha than the rest at the onset of the sample. Since then, however, all alphas have been relatively similar and time-varying.

Overall, we deduce that there's no systematic out- or underperformance of one group categorized by equity beta over another. Therefore, we recommend that if an investor is inclined to accept a certain equity beta, they should consider doing so via an Event-Driven allocation rather than through Equity Hedge managers. It's worth noting that many funds within the Event Driven group pursue a credit-focused investment strategy. In unreported results, we also conduct an analysis to pinpoint the sweet spot in terms of credit beta. The findings echo those of equity beta, with no discernible and consistent pattern when grouping by credit beta.



The landscape of Long-Biased strategies is characterized by notable diversity. Within Equity Hedge strategies, there's a pronounced cross-sectional dispersion in equity beta, and individual funds tend to maintain their beta with a remarkable consistency over periods. On the other hand, Event-Driven managers, while exhibiting less variability across equity beta, present more pronounced time series fluctuations for their individual funds.

From our extensive analysis, a pattern emerges for Equity Hedge managers: as their equity beta surges, their equity alpha dwindles. This underscores that managers operating with betas between 0.15 and 0.25 often deliver superior absolute returns compared to those operating with betas reaching 0.65. It's worth noting, however, that while managers with betas above one have indeed achieved enhanced absolute returns, they've also navigated extended phases of detrimental negative alpha. For investors whose sole pursuit is absolute returns, leveraging a straightforward ETF could have been more advantageous, affording them the benefits of reduced fees and eliminating the constraints of stringent redemption clauses.

Event-Driven managers chart a different course. A dominant proportion of them lean towards a lower beta framework, and our efforts to trace discernible performance patterns over time, be it with credit or equity beta, have proven inconclusive.

To encapsulate, our advise for investors is twofold. Firstly, when venturing into Equity Hedge strategies, a restrained, less directional stance is advisable, especially as justifying strategies with betas surpassing 0.3 becomes challenging. Secondly, for those investors with a preference for longer market directionality, channeling their resources into an Event Driven allocation is recommended. However, it's pivotal to recognize that the cohort of high beta Event-Driven managers is consistently outnumbered by their Equity Hedge counterparts.

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