Shifting Metrics in the Hedge Fund Industry

by: Nick Gogerty

Hedge fund metrics

The business of running a hedge fund is getting tougher on the performance side and the day to day office routine. Due diligence requests are up, redemptions are coming in and the staff is upset that the high water mark is receding faster than AIG's popularity. It can feel a bit like being the captain of the nautilus in 20,000 leagues under the sea.

Something else to look out for if you are a hedge fund manager. Inflation.

Many hedge funds don't think much about inflation at the business level and assume the quant guys will come up with a strategy or the trend following commodity approach you just started applying will cover it.

The problem is that if inflation comes back you are going to get hit with a metric shock at the business level and the market level. Many funds promised to deliver whatever would get people to buy them. Fund allocators, family offices, pension funds, seeders etc. would ask for relative returns or absolute returns. The benchmarks would be set and everyone would be on their merry way until the quarter or year end review.

The metric shifts with the fashions of finance. Those who thought relative performance to equities would keep them high and dry are surprised that 1,500 bps of alpha over a -30% S&P index is met with redemption calls instead of a pat on the back.

Because most investors in hedge funds bought the feel good story and didn't understand the process driving the returns, they are heading for the hills.

The metric of absolute positive returns has now come into fashion. Alpha shmalfa, liquidity, absolute returns and transparency are the watch words of the day.

Inflation metric surprise

So if you run a hedge fund here is something to think about from a business perspective, Inflation. Rarely will your allocators or investors mention real vs. nominal returns in today's conversations. That could change, yesterday's 15% absolute return with 1.0 Sharpe may not make such a bold statement if inflation spikes in the U.S. greater than 10%.

Historical Sharpe ratios could be viewed through the lens of CPI instead of t-bills if inflation returns. You may want to run the figures now to see how others could be looking at your returns when they fire up the Barra type tools for their annual CYA process reviews. Co-variance using CPI or another inflation metric could become an important factor (pun intended) in your business.

From a fund business perspective the smart FoF's or hedge fund manager may wish to consider an inflation linked exposure today before things get crowded. If inflation rears its head, the returns of hedge funds may start to look less appealing in a relative context. A stable 15% return looks pretty risky in a high inflation environment if the process driving returns isn't understood and that 15% is invariant with respect to inflation.

A smart thing to do right now is to run the frontiers and performance expectations against various inflation scenarios and metrics, then choose strategies and exposures accordingly. The only fund I have heard of publicly that does this is Bridgewater. Ray Dalio seems to have the 2 key assets required for long term wealth maximization, imagination and discipline.