Mini-Course Series - Alternative Investments (Part 3) by Institute of Business & Finance

MINI-COURSE SERIES ALTERNATIVE INVESTMENTS Part III

ALTERNATIVE INVESTMENTS

HEDGE FUND CONCERNS The goal of the advisor is to find hedge funds with a positive and upward bias. Equity market neutral and global macro have the most conservative risk profiles. The skew for equity market neutral hedge funds is only slightly negative, while the skew for global macro hedge funds is positive. Each of these strategies has a low kurtosis. For advisors who want to be careful and cannot justify the added fees of a fund of funds approach, both styles offer better risk-adjusted returns than the S&P 500. Market neutral managers have a more positive concentrated return pattern, while global macro managers experience a greater return dispersion.

Bias The basis for reviewing individual hedge funds as well as their strategic categories is performance. Biases of hedge fund data have been described earlier. This section expands upon that discussion. Survivorship bias means that funds no longer in existence, usually poor performers, are not part of the database. This exclusion leads to an upward bias in performance reporting. This also happens with mutual funds, but it is much more pronounced in the hedge fund world, partially since the numbers can be so extreme (largely due to the use of leverage) and because the percentage of hedge funds going out of business each year is high (~ 15%). A study in Hedge Fund News (August 1999) and the article Offshore Hedge Funds by Brown, Goetzmann, and Ibbotson, both estimate the average life of a hedge fund manager is just 2 ½–3 years. Most estimates are that just survivorship bias adds 300–500 basis points to database returns each year. A 2006 study by Fung and Hsieh shows how survivorship bias translates into category returns of 250 basis points higher per year; a study by Ibbotson covering the period 1989–1995 estimates this bias increases return figures by 200–300 basis points a year. Still yet another study by Ackermann, McEnally, and Ravenscraft (Journal of Finance, June 1999) finds no consistent bias; the authors believe that while a number of hedge funds stop reporting because of bad numbers, other funds stop reporting because their numbers are so good—it is not in their best interest to make such information public (probably because they are afraid of imitators). Selection bias means those funds that do well are more likely to report their results to a database than those still operating but have less than stellar returns. Ackermann, McEnally, and Ravenscraft believe selection bias adds ~ 140 basis points to reported hedge fund annual returns.

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Backfilling, sometimes called backfill bias, occurs when a fund’s historical performance is added to the database. This is a real concern since a hedge fund manager can withhold return figures and only contact a database when the fund’s entire track record looks good. A 2006 study by Ibbotson and Chen estimate backfill bias (instant history) is 500 basis points a year. A study by Barry believes instant history adds 40 basis points. Liquidation bias, also known as catastrophe bias, occurs when a fund’s returns are no longer good; the fund remains operational, but the management has decided to stop reporting results to different sources. For example, Long Term Capital Management stopped reporting returns just a month before it went bankrupt. The management knew things were beginning to unravel. A month later, the fund’s cumulative losses were ~ 100%. Including such a figure would have greatly lowered its category average for the month. The catastrophic bias may also be the result of a market or interest rate event—those hedge funds particularly hard hit would have a strong reason not to report results for that period and perhaps beyond. Ackermann, McEnally, and Ravenscraft believe liquidation bias adds 70 basis points a year to category returns. Short volatility bias, which is not included in the summary table on the next page, occurs when a hedge fund increases its short-term returns by collecting option premiums. The strategy cannot work indefinitely; an unexpected volatility event will eventually wipe out any of these short-term enhancements. Hazard bias refers to the proportion of hedge funds that drop out of a database at a given age. A 2006 study by Fung and Hesich found the highest database dropout rate occurs when a hedge fund is 14 months old. A large number of funds could be excluded from an index that required a fund to have at least a two-year record. Investability bias refers to hedge funds that continue to report their returns but do not accept new investors. The argument could be made that there are lots of indexes outside the world of hedge funds that include the same thing (i.e., there are rare coin indexes with coins that never trade hands and only a handful are in existence). There is also the legitimate opinion that such hedge funds should not be included in the index because they are likely to contain an upward performance bias. Fee bias occurs with a large number of hedge funds since individual investors are often able to negotiate fees. When the fund’s track record is particularly good, the investor’s ability to negotiate is lessened; when returns are weak, fee negotiation is more likely, particularly with larger investors.

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Side pocket bias exists whenever a hedge fund manager does not include the valuation (or returns) of assets it deems difficult to value. Thus, if there is any question about whether a poor performing hedge fund asset can be “fairly valued,” the hedge fund manager is likely to put it in a “side pocket” and ignore the issue altogether. If the asset later turns into a winner, it may surprisingly appear back in (and out of the side pocket) with the fund’s other assets for performance computation. Like other forms of bias, use of a side pocket allows a hedge fund manager to collect more fees. As previously discussed, Sharpe ratios have questionable value in the world of hedge fund comparisons. A 2002 study by Goetzmann, Ingersoll, Spiegel, and Welch shows how hedge fund managers can increase their Sharpe ratios, at least for some period, without having any skill. The strategy involves selling out-of-the-money calls and puts in an uneven ratio. This means that regular and ongoing income is created, but it also means funds are subjecting themselves to extreme events. The strategy shows itself with a return distribution with a shortened right tail and a fat left tail. The use of leverage can also help. The table below summarizes information from six different studies: [#1] Park, Brown, and Goetzmann (Hedge Fund News, August 1999); [#2] Brown, Goetzmann, and Ibbotson (Journal of Business, 1999); [#3] Fung and Hsieh (Journal of Financial and Quantitative Analysis, 2000); [#4] Ackermann and McEnally (Journal of Finance, June 1999); [#5] Barry (MFAC Research Paper, September 1992); and [#6] a 2006 study by Ibbotson and Chen.

Hedge Fund Database Returns: Impact of Biases Study #1

Survivorship Bias

2.6

3.0

0.0

3.7

5.7

Selection Bias

1.9

Instant History Bias

1.4

0.4

5.1

Liquidation Bias

0.7

4.5%

3.0%

4.4%

0.7%

4.1%

10.8%

Total

* Not estimated / ** No impact

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If these results are even fairly accurate, return figures for hedge fund database categories is incredibility misleading. For example, Study #1 comes up with a total of 450 basis points (4.5%) that should be subtracted from a hedge fund performance database for any given year—and this study did not include the added impact of backfill (instant history bias) or liquidation bias. Similarly, a number of other totals from the other five studies are also missing biases that could greatly increase their total return estimates. Even without factoring in all the biases described in previous paragraphs, the total for each study ranges from 70–1080 basis points per year. Based on this analysis alone, it does not seem hedge fund reporting services have much validity. Moreover, these biases cannot be diversified away by a “fund of indexes” since all indexes suffer from these biases.

Hedge Fund Performance According to Ibbotson, from 1995 through 2009, hedge funds had actual (adjusted for backfill and survivorship bias) compound returns of ~ 7.6% versus 8% for the S&P, 10% for small cap stocks, 8% for long-term government bonds, and 6% for medium-term government bonds. Industry data shows annualized pre-fee returns of 15% for hedge funds.

FEES By regulation, mutual funds and ETFs cannot accept an incentive fee; only a management fee can be used. Over 70% of investible hedge funds charge a 1–2% annual management fee; 80% of “live” funds also charge a 20% performance fee. Management fees for hedge funds range from 1–3% a year and incentive fees can be as high as 40%. Based on management incentives, a study by Kaxemi and Li shows a hedge fund is likely to increase its volatility (risk) if: [1] management is not poised to receive an incentive fee based on y-t-d returns, [2] fund NAV has been below its high-water mark for a significant period, and [3] fund assets are marketable enough to change strategies or leverage in order to try and enhance returns. The authors also believe small and newer funds are likely not to adjust their risk in order to earn more in incentives. Incentive (performance) fees are usually subtracted at year-end. Indexes provide monthly data that does not factor in or pro rate incentive fees. Thus, at the end of November for any given year, the funds in an index have accrued 11/12 of any incentive fee due; a number not subtracted from the index (or database). There is also the issue of fee consistency.

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Almost all hedge funds are structured as a private limited partnership. Negotiated fees are not known by other investors in the same fund. This means the rate of return will vary among investors. This also means an index’s return may overstate what a new investor could expect, particularly if some of the hedge funds in the index have an appealing track record (since they would then be less likely to reduce their fees to new investors).

AVOIDING THE HIGH-WATER MARK Hedge funds often include a “high-water” mark, meaning management does not collect its incentive fee until the fund surpasses its previous high. It has been argued that managers who are below this mark during the fourth quarter may become overly aggressive in the hope returns will be high enough by year-end to warrant a bonus. However, there is a way around this, without being reckless. A far easier solution is to close the fund and open a new one. When this happens, any former high-water mark disappears. This is exactly what John Meriwether did with JWM Partners; he closed JWM and put all the proceeds into JM Partners when the fund was down 44%.

REDEMPTIONS Each hedge fund has its own redemption policy. Most often, the policy states the request must be made at least a quarter in advance—if money is needed by year-end, the request had better be made before September 1st. A timely request does not necessarily mean the investor will receive back cash. A redemption request may mean the investor receives 90% of what is due, while the hedge fund holds back 10% until year-end accounting is finished—which is likely going to be April of the following year (even though the redemption was April of this year). Whatever percentage is received may not result in a check. Instead, the fund may be structured so that payment is in kind—such as illiquid securities from a bankrupt company. If the hedge fund is doing well, getting money out with the proper request should not be a problem. However, if the fund is in the middle of a large transaction and believes a liquidation could harm other shareholders, management may be able to “gate” the money (lock it up until a later, more convenient, time). If money is gated, which usually only happens during bad times, the investor will get it back in 1–3 years. PART III

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There is a common complaint among hedge fund investors that their money is not very accessible. While this can be true, there is also the reverse reality. A few hedge funds are so successful they want to return investor money as soon as possible. The fund’s manager may no longer want investor money since returns must be shared—once “gold” is hit, ditch investors and take all future profits (even though the risk of finding the successful investment was borne by the investors).

PORTFOLIO CONSTRUCTION A major theme in the study of any alternative investment is whether or not it should be added to a client’s portfolio, and if so, how much. Most public pension funds have < 5% of their assets in hedge funds. A number of studies show the best risk-adjusted return portfolio would have a 100% weighting in hedge funds. Obviously, this is something few, if any, of an advisor’s clients would go along with. At the other end of the spectrum, investors who can tolerate high risk are likely to have 0–2% of their holdings in hedge funds. It is important to keep in mind asset allocation models that include hedge funds as potential parts of a portfolio suffer from the same hedge fund database and index biases described earlier; overall, this means hedge fund returns are likely to be overstated by at least 300–500 basis points a year. An overstatement of just 50 basis points could greatly increase the recommended weighting of a hedge fund in an asset allocation program (software). The next table compares three traditional indexes to a large number of different CISDM hedge fund indexes for the period 1990–2008 (source: CISDM).

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Traditional Indexes vs. Hedge Fund Indexes [1990–2008] Return

Std. Dev.

Skew

Max. Loss

Corr.*

Bonds (Barclays)

0.2

-10%

0.1

S&P 500

16%

-0.7

-45%

0.6

EAFE

18%

-0.6

-49%

0.5

Fund of Funds

-1.3

-18%

1.0

Equal Weight

13%

-0.7

-21%

0.9

Merger Arbitrage

10%

-1.1

-6%

0.7

Global Macro

11%

1.1

-8%

0.6

Event-Driven

11%

-1.6

-20%

0.8

Equity Mkt. Neutral

-0.5

-3%

0.6

Equity Long-Short

12%

-0.3

-17%

0.8

Distressed Securities

12%

-1.4

-21%

0.7

Convertible Arbitrage

-5.1

-22%

0.7

CTA Asset Weighted

11%

0.6

-11%

0.1

CTA Diversified

10%

12%

0.4

-17%

0.1

CTA Discretionary

12%

0.8

-6%

0.4

CISDM Hedge Fund Index:

* Correlation to the CISDM Fund of Funds Index

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