Hedge Fund Performance: It's the Driver That Matters

by: Veryan Allen

Hedge funds returns have ranged from -100% to +1000% this year. Most years have a similar spread as a few blow up while someone else bets the house and happens to be right. The average return disguises so much inaccuracy and dispersion that the average is irrelevant. Databases include lots of "hedge funds" that aren't and miss lots of good and bad real hedge funds that don't report.

Since good results are unbounded to the upside but losses are floored at -100%, such a positive skew and the distorting effect of extremely high performing outliers will make the "mean" return higher anyway. But there is the bigger issue of what performance investors are trying to identify, measure and access.

The purpose of any hedge fund is surely to offer a source of performance NOT obtainable from a traditional fund. This would imply that the "performance" to really measure is the risk-adjusted true alpha that a manager extracted from their opportunity set. The idiosyncratic returns contributed over and above what the underlying factors added. If you do this you get a very different ranking of performance than what the headlines suggest. It is the QUALITY of the returns that matters, not only the QUANTITY.

Obviously I favor hedge funds but many of the concerns critics raise on general hedge fund industry issues ARE legitimate. For asset allocation unhedged traditional funds have lower fees, lower due diligence costs and more liquidity and transparency even though they do little to mitigate risk. Therefore IF a return source can be accessed through a traditional product that is the way to go. The ONLY reason to invest in ANY hedge fund is if it can produce a risk-adjusted return that would not have been accessible in a simpler way.

Unfortunately many products purporting to be hedge funds are dependent on the underlying asset class going up: Leveraged beta disguised as alpha. It is also easy to appear uncorrelated but the "alpha" can still be beta. Many of the basic high school linear statistical measures are useless. A high volatility equity can have zero beta. A low volatility fund can have enormous risk. A low correlated fund can be 100% dependent on the underlying.

Conversely a fund with a correlation of 1 can STILL be a valuable diversifier! A high volatility hedge fund can be low risk and REDUCE the volatility in a portfolio. Some of the riskiest strategies in isolation have the opposite function in that they lessen total portfolio risk. This rather nullifies the performance stats hedge funds and funds of hedge funds email out each month. HOW the return was made can be more important than WHAT the return was.

If you are sure the stock market is going up next year you probably do NOT need any hedge funds in your portfolio. If you think oil, gold, Chinese real estate or anything else is going up, there are better ways to implement and possibly profit from that view than a hedge fund. But if you want exposure to the opportunities created by the mispricing and anomalies in and between asset classes, ESPECIALLY if the asset class goes down, then that is the main reason to invest in a hedge fund.

Most investors already have enough exposure to general economic growth and long only. There are as many one hit wonders in investing as there are in music or movies. Every year there will inevitably be traders that make a very concentrated bet on some idea and that idea proves to be correct. Whether they can keep on finding ideas that work and can hedge risk in case their next idea is wrong is much rarer. Some good funds had a flat to slightly negative year while some lucky funds had enormous returns but one year counts for little.

Edges are only detectable from luck over long periods of time. Even index and mutual funds will be ramping up marketing in 2008 now their 5 year performance looks acceptable. As with hedge funds, investors would be wise to look at longer time scales, return on risk and exposure to drawdowns. A fund manager that makes 15% CAGR over 15 years is more impressive than one that makes 1,000% in 1 year.

Hedge funds have apparently "outperformed" equities in 2007. So? Hedge funds are supposed to offer an alternative source of return. How equities or any other asset class performs is irrelevant. Hedge funds are strategy classes. And what "equities" are we talking about? The MSCI World index is not very worldly anyway. Compared to Chinese indices, average hedge fund returns have been pathetic; compared to Japanese indices average hedge funds returns have been brilliant. So what?

Whether a hedge funds underperforms or outperforms any asset is of no importance; it is the different driver of performance that matters. I've blogged before that most of the -100% funds this year were not hedge funds anyway. That was clear to me well before they imploded. But non-hedge funds marketing themselves as hedge funds cuts both ways. Several of the funds that have made +100% this year are also NOT hedge funds. What amounts to long only bets on equities, commodities or other assets is not a hedge fund strategy even if there is supposedly a modicum of shorting or hedging going on. Making money when the underlying goes up and losing money when the underlying goes down is a closet INDEX fund not a hedge fund. Why pay hedge fund fees for performance obtainable from simpler funds?

No-one makes money all the time, of course, but losing money is better when other things in the portfolio are making money. Emerging markets have been the best "performer" this year though comparatively few "hedge funds" operating in the space actually are hedge funds. Much of the returns have been driven by beta. If a manager can't make money in the absence of beta then it is not a hedge fund. If you think China, India or Brazil equities are going up, buy ETFs like iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI), iPath MSCI India Index ETN (NYSEARCA:INP) and iShares MSCI Brazil Index (NYSEARCA:EWZ) or some other long only product.

There is no logical reason to pay 2 and 20 to what amounts to a long only stock picker running what they say is a hedge fund. I've met several Indian and Brazilian fund managers recently and usually ask them how they would have done if the BSE or BOVESPA was down 50%. The good ones would still make money or at least preserve capital in that scenario. Not the bad ones though...

At the moment everyone loves Chinese and Indian hedge funds and hates Japan focused hedge funds. Obviously the headline absolute performance is vastly higher with many of the former up over 100% while many of the latter are up less than 10% or even negative. But if you compare their alphas as I define alpha: observed return minus expected return generated from their security universe adjusted for exposure and risk - the "performance" of a +10% Japan hedge fund could be argued to be superior to a +100% China hedge fund.

Asia is a big place with half the world's population so the "Asia hedge fund" moniker generalizes too many different things. Jordan and Japan present very different investment opportunity sets. There are a lot of stocks, bonds and real estate to look at between Jakarta and Jerusalem. Alpha is surely what has been generated from a particular opportunity set adjusted to reflect the risks. A US fund that makes 20% picking S&P 500 stocks has probably done a better job than a fund that makes 30% picking obscure US microcaps. A Germany long short fund that produces 20% has likely done better than a Russia fund up 40%. If a fund sets up to invest in art, violins or uranium, then it must demonstrate how it will STILL make money when art, violins or uranium go down.

There are many "niche" strategies knocking around these days that use the hedge fund label to be trendy but have little to to with hedge funds. There have also been lots of portable alpha mandates recently. But these are only of value if it really is alpha NOT with beta mixed in. Asset allocation overlayed with strategy allocation is impossible if it just adds more beta to the portfolio INSTEAD of adding alpha. Asset allocation is long only and rightly so therefore strategy allocation should only be about strategies that perform when long only doesn't.

Many hedge fund investors hate short only strategies so it is ironic that short only credit and short only US dollars were by far the best alpha generators this year. Perhaps next year short only equities will be the trade, though which equities I have no idea. But whatever happens, the performance that matters is how much money was made from how much risk in a DIVERSIFYING way.