Practical analysis for investment professionals
24 July 2023

When Hindsight Becomes Foresight: Replicating Investment Performance


We have analyzed dozens of public and private market investment strategies, such as merger arbitrage and private equity, respectively, over the last few years, and one common theme has emerged. Most of the products described in more than 300 research papers simply provide exposure to the stock market in complicated wrappers. Once the tide goes out, the risk exposure is the same everywhere.

We can demonstrate this phenomenon in different ways. The most common approach is to simply run a factor exposure analysis. Investment products marketed as offering uncorrelated returns often exhibit high betas to the stock market, which highlights a lack of diversification benefits.

But there is an even simpler and perhaps more powerful way to illustrate this point: by using a combination of the S&P 500 and cash to replicate the historical performance of an investment product with the same level of risk.

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We recently created Time Machine, a freely accessible tool with which investors can replicate the performance of any mutual fund, exchange-traded fund (ETF), or US stock using just the S&P 500 and cash.

To demonstrate Time Machine’s facility on social media, we analyzed the iMGP DBi Hedge Strategy ETF (DBEH), which tracks the 40 leading longshort equity hedge funds, and found that an 81% allocation to the S&P 500 and a 19% allocation to cash would have delivered almost the same performance with the same volatility.

Replicating a Long–Short Hedge Fund ETF with the S&P 500 and Cash

Chart showing the effects of Replicating a Long-Short Hedge Fund ETF with S&P 500 and Cash

Source: Finominal

From our perspective, these Time Machine results called the utility of this ETF into question. A respected Twitter commentator, on the other hand, countered that the fund’s three-year track record was too short to draw any conclusions and that our replication process was simply based on hindsight. These were fair points, so we expanded our analysis.

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Long–Short Equity Hedge Fund Performance

Since the goal is to replicate equity-like returns with less risk, or exactly what a S&P 500 plus cash portfolio provides, we use long–short equity hedge funds as case studies. To evaluate each, we selected indexes that have extended histories across multiple market cycles. The Eurekahedge Long Short Equities Hedge Fund Index and HFRX Equity Hedge Index both have 20 years of history, which should be sufficient.

But Eurekahedge has a CAGR of 8.1% versus 2.0% for HFRX. Given that both aggregate the returns of single long–short equity hedge funds, such a large discrepancy is alarming and makes it difficult to evaluate each strategy’s attractiveness. Which one is better?

Of course, the number of funds in each index varies, but the crucial driver may be that Eurekahedge allows new fund managers to import their past track records once they start reporting. Since only fund managers with good past performance ask to be included in these indexes, a form of survivorship bias may be at work. So, capital allocators would be wise to ignore the Eurekahedge index and focus, as we do in the rest of our analysis, on the more realistic HFRX.

Long-Term Performance of Long–Short Equity Hedge Funds

Chart showing Long-Term Performance of Long-Short Equity Hedge Funds

Source: Finominal

Replicating Long–Short Hedge Funds

The HFRX Equity Hedge Index’s volatility was 6.1% over the 2003 to 2023 period, which we could have replicated with a 52% allocation to the S&P 500 and 49% to cash. But the replication portfolio’s CAGR would have been 3.7% compared with 2.0% for the hedge funds, and the drawdown would have fallen from 31% to 19%. This results in significantly higher risk-adjusted returns for the replication portfolio.

To be sure, investors do not have to conduct any due diligence on the S&P 500, whereas hedge fund analysis is an expensive process that requires an initial assessment as well as ongoing monitoring. Furthermore, an S&P 500 ETF today has basically zero expenses, while hedge funds come with high management and performance fees. So, who wouldn’t favor the replication portfolio?

Replicating HFRX Equity Hedge Index with S&P 500 and Cash

Source: Finominal

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Further Thoughts

Although a simple S&P 500 and cash portfolio would have achieved higher absolute and risk-adjusted returns than long–short equity hedge funds, might our analysis still be based on hindsight and have little relevance for expected returns?

Yes, but given the 0.71 correlation between the HFRX Equity Hedge Index and the S&P 500, there is little question that long–short equity hedge funds offer diluted equity exposure.

Furthermore, the HFRX index’s upside beta to the S&P 500 was 0.16 compared with 0.25 on the downside. As such, equity hedge funds follow falling stocks more than rising ones. Obviously, this ratio is at parity for any S&P 500 and cash combination.

At some point, hindsight becomes foresight.

For more insights from Nicolas Rabener and the Finominal team, sign up for their research reports.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Ryan Djakovic

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About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of Finominal, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

1 thought on “When Hindsight Becomes Foresight: Replicating Investment Performance”

  1. Rowan Williams-Short says:

    Another great article – thank you Nicolas. I spent two years running funds of hedge funds from London. We invested in all the major strategies from California to Tokyo. Like you, I detected that I could replicate most, at much lower costs.

    Despite that, the majority of HF managers I encountered proclaimed themselves intellectually superior to long-only managers, and attempted to justify egregious (*) fees that way. With few exceptions (a fixed income arbitrage manager in Hong Kong stood out, for example), their claims were wholly unjustified.

    A suggestion on the hindsight bias issue: use the standard statistical out-of-sample technique. In this case, pick the ratio of S&P500:cash on volatility matching criteria using only the first 15 years of data, and then see how the subsequent 5 years perform.

    (*) One NYC equity market neutral manager was charging 5/50. I assume this was just to see if anyone was stupid enough to accept that.

    Final thought: I was amazed to read in your article that there are still index managers who permit “backfilled” performance. This just invites self-selection bias.

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