The founder of CEO of MSR Indices, a Parsippany, N.J.-based index-investors consultancy, has authored a white paper on target volatility, also known as intertemporal risk parity.

The gist of the paper is that: (1) equity hedge funds do secure alpha for their investors, obvious if one measures their performance against traditional equity indices on a risk adjusted basis; and (2) that they do this through employing intertemporal risk parity, rather than through intuitive stock picks or insider tips.

BHFI and GEDWTR

As a preliminary matter, the paper begins with a discussion of whether hedge funds create diversification. The writer, Michael S. Rulle, observes that the Barclay Hedge Fund Index (BHFI) is in fact highly correlated with long-only equities, as reflected for example in the MSR Global Equity Dollar Weighted Total Return Index (GEDWTR).

The underlyings of the GEDWTR are about 43% US, 43% Europe, and 14% Japan. Dividends are reinvested and there is daily rebalancing.

The monthly correlation between GEDWTR and BHFI is .84; annual correlation is .94.

One cannot invest in the BHFI. But from an analytical perspective, those numbers suggest it is “virtually an equity replacement.” On the other hand, the hedge funds in the equity replacement do better than equities, in risk-adjusted terms.

MSR adjusts the Sharpe ratio to take account of what it sees as a mistake in the usual computation of that ratio. It is usually calculated on the assumption that hedge fund performance month-to-month is a “random walk,” that is, that there is no “serial correlation.”

As a refresher for non-wonks: serial correlation is a relationship between any variable and the lagged version of itself. The traditional example is a coin flip. There is no relationship between the fact that this coin came up “heads” the last time I flipped it and the possibility that it will come up “heads” the next time I do. None whatsoever.