Hedge Fund Performance During Recessionary Periods
- Oct 2024
- AlternativeSoft
Introduction
Recessions bring economic slowdowns, market volatility, and uncertainty, making it essential for investors to anticipate downturns and adjust their strategies accordingly. Sahm Rule Recession Indicator [1] was triggered this August, signaling that a recession could be on the horizon. The Sahm Rule activates when the three-month average of the U.S. unemployment rate rises by 0.50 percentage points or more from its lowest point over the past year, indicating that the economy is likely entering a recession. The last two times this indicator was triggered were during the 2008 financial crisis and the COVID-19 downturn in 2020. However, the potential upcoming recession may differ significantly from both. Today, the economic landscape is shaped by higher interest rates, geopolitical tensions, such as the ongoing war in Ukraine, and emerging conflicts in the Middle East. It is important to study these past recessions to understand how hedge fund strategies performed under different economic pressures and to better prepare for the potential downturn ahead.
In our analysis of past recessions, hedge funds that employed low beta and market-neutral strategies demonstrated remarkable stability and risk mitigation during both the Global Financial Crisis of 2008 (GFC) and the COVID-19 recession. The CTA strategies showed strong resilience throughout these periods, delivering positive returns while many other strategies suffered significant losses. Meanwhile, equity-related strategies that struggled during the GFC managed to thrive during the pandemic, benefiting from rapid government interventions and a swift recovery in sectors like healthcare and technology. As we navigate this evolving landscape, understanding which hedge fund strategies can effectively balance risk and reward in different types of recessions will be crucial for overcoming the challenges ahead.
Research Approach and Methodology
To explore this, we’ll use the Sahm Rule as a marker for identifying past recessionary periods (see Figure 1 below) and focus on the 2008 Global Financial Crisis and the 2020 COVID-19 recession, as data for hedge funds is unavailable for earlier recession periods. These two downturns had very different causes, so comparing hedge fund performance during both will show us how various strategies reacted to those specific challenges. We’ll examine key performance metrics like Annualized Return, Volatility, Sharpe Ratio, and Value at Risk (VaR) over the 12 months following each recession, as this period is long enough to provide insight into how different hedge fund strategies performed.
Figure 1: Sahm Rule Recession Indicator
Source: Federal Reserve of St. Louis.
How Different Recessions Impact the Markets
It’s crucial to understand that not all recessions are alike. The underlying causes of a recession shape how markets behave and how different hedge funds perform. The Global Financial Crisis was caused by systemic failures in the banking and housing sectors, which led to a liquidity crisis and a long, painful recovery. On the other hand, the COVID-19 pandemic caused a sudden disruption in supply chains and consumer behavior, but swift government intervention, through fiscal and monetary support, helped soften the blow.
Hedge Fund Performance: 2008 Financial Crisis vs. 2020 COVID-19 Pandemic
Hedge funds aim to protect against market downturns, but their performance can vary depending on the type of recession. The table below highlights how key hedge fund strategies performed during the 2008 Global Financial Crisis and the 2020 COVID-19 recession, using metrics like Annualized Return, Volatility, Sharpe Ratio, and Value at Risk (VaR).
Table 1: Hedge Fund Strategies Performance in the 12 months following recessions
Index |
Return -COVID-19 |
Return - Global Financial Crisis |
Volatility Covid – COVID-19 |
Volatility - Global Financial Crisis |
Sharpe Ratio – COVID-19 |
Sharpe Ratio - Global Financial Crisis |
Normal monthly VaR 99% -COVID-19 |
Normal monthly VaR 99% - Global Financial Crisis |
HFRX Macro/CTA Index (Flagship Funds) |
6.28% |
3.41% |
3.58% |
7.39% |
1.74 |
0.04 |
-1.89% |
-4.66% |
HFRI 500 Equity Hedge Index |
40.73% |
-19.41% |
9.31% |
13.09% |
4.37 |
-1.72 |
-3.33% |
-10.51% |
HFRI 500 EH: Equity Long Short Index |
44.88% |
-21.83% |
10.10% |
14.93% |
4.44 |
-1.67 |
-3.61% |
-11.97% |
HFRI 500 EH: Equity Market Neutral Index |
10.46% |
-3.82% |
3.89% |
4.45% |
2.67 |
-1.56 |
-1.77% |
-3.30% |
HFRI 500 ED: Distressed/ Restructuring Index |
37.25% |
-21.98% |
14.02% |
13.41% |
2.65 |
-1.87 |
-6.67% |
-10.98% |
HFRI 500 Event-Driven Index |
35.58% |
-18.20% |
6.96% |
11.65% |
5.11 |
-1.83 |
-2.09% |
-9.43% |
HFRX Fixed Income - Credit Index |
18.94% |
-5.36% |
5.28% |
10.81% |
3.58 |
-0.78 |
-2.08% |
-7.68% |
HFRI EH: Sector - Energy/Basic Materials Index |
73.96% |
-29.47% |
14.03% |
26.40% |
5.27 |
-1.23 |
-4.63% |
-20.31% |
HFRI 500 EH: Healthcare Index |
34.84% |
-8.20% |
11.09% |
10.84% |
3.14 |
-1.04 |
-4.88% |
-7.95% |
HFRI EH: Sector - Healthcare Index |
42.26% |
-2.05% |
11.46% |
10.12% |
3.68 |
-0.51 |
-4.67% |
-6.93% |
HFRI EH: Sector - Technology Index |
38.97% |
-10.38% |
9.91% |
12.76% |
3.93 |
-1.06 |
-3.84% |
-9.42% |
HFRI 500 Low Beta Index |
17.26% |
-4.23% |
2.37% |
5.93% |
7.25 |
-1.24 |
-0.26% |
-4.33% |
S&P500 Index |
53.71% |
-37.01% |
17.27% |
27.92% |
3.11 |
-1.44 |
-7.84% |
-22.22% |
Source: AlternativeSoft and HFR Database
Insights from Hedge Fund Performance Comparisons
- Event-Driven and Equity Hedge Strategies
Event-Driven and Equity Hedge strategies, which typically rely heavily on equities, were hit hard during the 2008 financial crisis but bounced back impressively during the COVID-19 pandemic. The Global Financial Crisis brought about a collapse in the financial system, which caused major losses for these strategies. For example, the HFRI Equity Hedge Index recorded a significant loss of -19.41% in the 12 months following the recession indicator, reflecting the sharp market downturn. However, during the COVID-19 recession, the same index performed much better, achieving a 40.73% return, driven by the market's swift recovery thanks to government stimulus and supportive monetary policies.
This difference shows how equity-heavy strategies struggle when a recession is caused by financial instability, but they can thrive when the recession stems from more specific disruptions—like the pandemic—which led to strong rebounds in sectors such as healthcare and technology. - Macro and CTA Strategies
The HFRX Macro/CTA Index showed strong resilience during both the 2008 Global Financial Crisis and the COVID-19 recession, delivering positive returns while many other strategies saw big losses. While most hedge funds struggled in 2008, this strategy still performed well, proving its ability to handle extreme market disruptions. Even though returns were lower and risks higher in 2008, the index stayed stable compared to the sharp drops in other sectors. During the COVID-19 recession, it performed even better, with stronger risk-adjusted returns. This ability to adapt and manage risks through both crises highlights the strength of the CTA strategies in tough economic times. - Market Neutral and Low Beta Strategies
Hedge funds using market-neutral and low beta strategies, which aim to reduce exposure to overall market swings, showed strong stability in both recessions. These strategies seek to hedge out market risk, relying on low-risk or relative value strategies.
During the GFC, the HFRI 500 Low Beta Index posted a modest loss of -4.23%, but this was a much better performance compared to the broader market's severe losses. During the COVID-19 recession, this index did even better, posting a 17.26% return. Similarly, market-neutral strategies delivered positive returns in the COVID-19 period, with the HFRI 500 EH: Equity Market Neutral Index returning 10.46%, compared to a loss of -3.82% during the GFC.
These strategies offer consistency and risk mitigation, making them valuable tools during periods of uncertainty, regardless of the specific drivers of the recession.
Volatility and Risk Management in Different Recessions
Managing volatility is one of the biggest challenges during recessions. The 2008 Global Financial Crisis saw extreme levels of volatility, with the S&P 500 experiencing annualized volatility as high as 27.92%. By comparison, volatility during the COVID-19 pandemic was lower, peaking at 17.27%. Hedge funds, especially those with a focus on managing risk, generally handled this volatility better than traditional asset classes.
For example, the HFRI 500 Event-Driven Index had lower volatility in both recessions (6.96% during COVID-19 and 11.65% during the GFC), showing the important role hedge funds can play in helping investors navigate extreme market swings. Additionally, when we look at Value at Risk (VaR), a measure of potential maximum losses, we see that risk was much higher during the GFC. The HFRI 500 Equity Long/Short Index had a VaR of -11.97% in 2008, compared to just -3.61% during the COVID-19 recession, reflecting the more manageable risks during the pandemic.
Sharpe Ratio: Risk-Adjusted Returns
The Sharpe Ratio, which measures how efficiently a strategy generates returns relative to the risk taken, provides valuable insights into hedge fund performance across different recessions. Hedge funds focused on preserving capital and minimizing risk, like low beta strategies, performed particularly well during the COVID-19 pandemic. For example, the HFRI 500 Low Beta Index posted a Sharpe Ratio of 7.25 during the COVID-19 recession, compared to -1.24 during the GFC, highlighting the superior performance of low-risk strategies during the pandemic.
Similarly, Event-Driven and Equity Hedge strategies, which generally take on more risk, saw stronger Sharpe Ratios during the COVID-19 pandemic compared to the GFC, as certain sectors like healthcare and technology rebounded quickly following the initial shock.
Conclusion
With a potential recession on the horizon, it's clear that not all downturns affect the markets equally. Past recessions, such as the 2008 Global Financial Crisis and the 2020 COVID-19 pandemic, show that the root cause of the recession—whether it’s financial instability or sector-specific disruptions—greatly influences how hedge fund strategies perform.
During both periods, the CTA strategies demonstrated strong resilience, delivering positive returns while many other strategies suffered significant losses.
Low beta and market-neutral strategies have consistently provided stability and risk mitigation in both types of recessions, making them valuable tools for uncertain times. On the other hand, equity and event-driven strategies, which struggled during the GFC, thrived during the COVID-19 recovery, highlighting the need for a tailored approach to strategy selection.
As we face a possible recession shaped by higher interest rates, geopolitical tensions, and supply chain disruptions, a balanced, diversified approach that includes market-neutral, macro, and selective event-driven strategies will be key to managing risk and capturing opportunities.
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