by Jason Voss, CFA
Evaluating the quality of a money manager is a perennially important topic. It's all the more important when that money manager charges 2% of assets under management and 20% of any gains. Yes, that age-old conundrum of how to choose a good hedge fund for your portfolio remains a difficult task. But Mark J.P. Anson, CFA, CAIA, thinks he has bright light to shine on the problem. As the person responsible for alternative assets at the Bass Family Foundation, he enjoys wider sight lines than many other investors who have taken the plunge into hedge funds.
At last week's 2013 Asset and Risk Allocation conference in New York, Anson began his presentation with a Sherlock Holmes-like quote: "When you have eliminated all of the beta, whatever remains, however improbable, must be the alpha." In other words, if you want to identify a skilled hedge fund manager, you need to dissect the many factors (betas) leading to an actual return (alpha). Unfortunately, Anson suggests, most of the recorded alpha of hedge funds as an asset class is actually an underestimation of liquidity beta.
Privately traded assets have low betas relative to public markets. The theory is this is because private market asset pricing is not driven by public market fluctuations. But Anson believes this is a ridiculous assertion. After all, private equity is affected by similar forces as is public equity: the quality and level of economic growth, the employment picture, global trade regimens, and so forth. What is different about illiquid assets is the time it takes for private market prices to reflect factors as public markets do. Consequently, when evaluating hedge fund returns, Anson uses lagged market returns. By regressing hedge fund returns for the current period plus several prior market periods, he is able to reduce much of the reported alpha of hedge funds.
"Well that's just great," you might say. "Now what do I do since single-period regressions are not useful for identifying good hedge fund managers?" Anson suggested a useful and simple model for evaluating the quality of hedge fund managers (or any money manager, really): The expected quality of a hedge fund manager is a function, he argues, of additional return, minimal volatility, a bias toward positive returns, and less big blowups.
If you speak quant, that formula can be written as:
E[U] = α - β1σ + β2(skewness) - β3(kurtosis)
Anson argued that this simple formula properly rank orders quality money managers and does as well as polynomial goal programming and other statistical techniques, but without the extreme complexity.
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.