Hedge Fund Best Ideas During COVID-19
How COVID-19 affected our Novus Conviction Index, based on hedge fund public filings: performance, volatility, contribution, and sector trends.
As we enter the final of leg of Q2 2020, investors are still monitoring their recovery from the COVID-19 drawdown of Q1. While we’ve already analyzed the impact of the outbreak of the novel coronavirus through 13F fillings of the Novus Hedge Fund Universe (HFU) and the lens of the European Short Observer, this post aims to analyze COVID-19’s impact on the collection of stocks known as “hedge fund best ideas.”
The best insight into best ideas remains our flagship Novus Conviction Index. As a reminder, this index tracks stocks that managers show conviction in as proven by their willingness to size up a name, you can read more about the index in our previous post.
While our past research on conviction has typically dealt with a portfolio of the top 20 names, we extended our analysis here to a portfolio of 50 names to analyze a few key metrics: performance, volatility, contribution, and sector trends.
Conviction in 2020
Starting off with year-to-date (YTD) cumulative performance in Figure 1, we see that the index has outperformed the S&P 500 and the Russell 3000 during 2020.
While returns were largely moving with the market in the peak of the drawdown, the ‘recovery’ of the index, starting in April, was much faster than that of the two benchmarks. On April 30th for instance the index was down around 3% while the S&P 500 and Russell 3000 were still down approximately 9 and 10% respectively. This behavior has resulted in an impressive 6% cumulative return as of June for the index, with the market still catching up.
Risk and Reward
As is the case with any drawdown, an important consideration here is volatility. We’ve observed in the past how conviction’s standing as Novus’ flagship index is a result of both (a) consistent alpha generation, and (b) limited volatility. Figure 2 below enables us to compare the YTD risk-return tradeoff achieved by the Conviction index against the S&P, Russell and MSCI as well as the Novus HFU.
We can see that while Conviction has a higher volatility profile as compared to the S&P 500 and the MSCI ACWI, it generates substantially higher returns compared to all portfolios. This point is further supported by the Sharpe ratio, represented by the size of the bubble in Figure 2. A larger bubble indicates a higher Sharpe ratio, which in-turn reflects a higher return yielding capacity for each additional unit of risk taken. If we look at the actual numbers (listed in Figure 3 below) we see that Conviction has both a (significantly) higher Sharpe and Sortino ratio, indicating that the index’s high returns compensate investors for both the higher risk and higher downside risk taken.
Herd Mentality vs. Wisdom of the Crowd
For securities in the Conviction Index, an alternative measure of risk revolves around the measure of crowdedness. Another “C” in the Novus 4Cs is actually dedicated entirely to crowdedness. And while we typically see little overlap between the Conviction and Crowdedness indices, Figure 4 reveals an interesting shift within Conviction’s crowdedness this past quarter, compared to previous quarters.
We observe that while a portion of the portfolio by nature has always been crowded in the past, almost the entire portfolio in Q1 of 2020 was substantially crowded. Whether this indicates a fundamental shift in the risk profile of the index altogether, or is merely a consequence of recent events, time will tell.
COVID-19 Takeaways: Drawdown
If we restrict the time period of analysis to the market drawdown (lasting approximately from February 20 to March 31) there is even more to learn.
Conviction struggled in the initial stages of the drawdown, losing ground to the S&P 500 slightly, but still keeping in-line with the Russell 3000. It was only towards the end of March that returns picked up for the index, enabling it to gradually surpass the two benchmarks.
The Novus Framework (Figure 6) could lead us to conclude that negative sector contribution, beyond the impact of the market, was the culprit. While this may have worked against Conviction in the drawdown, expanding the timeframe to YTD (Figure 7), we can see this factor has been additive on a YTD time range.
Sector Trends and Impact
Throughout the height of the crisis (spanning February 20 to the end of March), most sector exposures remained at the levels they were at previously, with all but Information Technology (IT) decreasing in April.
Let's explore the details of these sector changes:
- Information Technology (red line), the favorite sector in the index, witnessed a small reduction in exposure in March, but then increased to its highest level of exposure since 2019 in April—as hedge funds flocked to tech companies who easily adapted to remote working.
- Health Care exposure (dark green line) and Communication Services (dark blue line) both increased slightly through the end of the drawdown, and then dropped sharply.
- Financials (light orange line) largely followed the pattern of Health Care and Communications, but with more erratic minutia through the end of March.
- Real estate exposure (brown line) entered in April, after not featuring in the portfolio at all in Q1 of 2020. Energy (dark orange) also showed up in April, after being present in February and then disappearing during the drawdown in March.
Now let's look at the contribution resulting from these shifts.
We can see how these shifts did in fact impact the portfolio during the drawdown:
- Financials was the largest detractor throughout the drawdown, and was also slow to recover despite the reduced exposure in April.
- Increasing Health Care exposure, on the other hand, turned out to be a beneficial given that the sector not only detracted less (relatively) in the drawdown. It appears that the mixture of pharmaceutical and insurance companies that made up the Health Care basket during the period of analysis enabled a quick recovery in the aftermath of the crisis.
- Similarly, Communication Services, despite having almost double the number of names in the index compared to Health Care, also detracted less in the peak of the drawdown and was quick to recover in April.
- Heavy IT exposure hurt the index in March, but scaling up the exposure thereafter was additive, as this sector was quick to recover—reflective perhaps of the resilience tech firms have shown in this pandemic, and corroborated further by the impressive quarterly earnings many firms reported in May.
While hedge fund long books may have struggled in the drawdown brought about by COVID-19, the analysis of the Novus Conviction portfolio indicates that Best Ideas strategies are still able to weather the storm.
Best Ideas: Live Discussion with Barclays
Join us for a virtual panel with Novus CEO Andrea Gentilini and Barclays on “Liquid Alternatives: 13F – Utilizing the Best Ideas of Hedge Fund Managers,” June 10, 2020 at 12:00 pm EDT. We will cover various topics including how alternative data can be interpreted and applied to an investment strategy, and liquid alternatives with a focus on implementing an equity long/short component as a portfolio diversifier.
This panel is open to all US institutional investors. Call-in details can be found here.
Note: The Novus Conviction Index is not an investible product. In 2016, Novus entered into a data partnership with Barclays to develop an investable index family based on the Conviction Index.