When November hedge fund returns began to trickle in early last week, they appeared to be in line with historical results in relation to equities. That’s not say that the numbers were stellar. But many strategies’ returns fell on or close to their long-term linear regression line (vs. the S&P). Then came the Madoff fiasco.

Over the weekend, Credit Suisse adjusted their initial estimate for the “Equity Market Neutral” category from basically flat to *minus *40% to reflect the fact that three of that sub-index’s constituents have apparently logged -100% returns (Kingate, Fairfield Sentry, and Rye Select according to Marketwatch). While this adjustment does not seem unwarranted, it does raise some important questions:

- The funds are assumed to have a November return of -100%. But what about previous months? While Bernie Madoff seems to have let the cat out of bag last week, the funds would have had a questionable value in all previous months as well. Assigning the entire loss to November may be the only prudent action without further information, but the drawdown could also arguably have been placed in
*December’s*results, not November’s. - Are asset-weighted hedge fund indexes too concentrated? While the occurrence of anomalies in any data set can serve the useful role of “baking in” the probability of outliers, the Madoff affair will be forever immortalized in a strategy track record that has a massive 40% drop-off right in the middle of it. This will make it difficult for academics and practitioners to analyze the
*investment*potential of the strategy without polluting their analysis with important, but*exogenous*, variables such as operational risk and regulatory oversight. - Adding a -40% return to the data set for an equity market neutral index makes skew and kurtosis virtually useless. For example, when you change last month’s flat return to a -40% return in the HFRI returns, for example, the result is an increase in excess kurtosis from 1.5 to 181.00 and an increase in the skew from 0 to around -12.0. So we ask a question familiar to Canadian and Finnish investors whose equity indexes were overwhelmed with mega-caps Nortel and Nokai in 1999:
*Is an alternate “Market Neutral ex-Madoff Feeders” index now required?*

While Madoff himself says that all the money is gone, we’re more than a little curious about the actual performance of his alleged investment strategies (whatever they actually were). In other words, what was the actual return of the split strike conversion strategy?

In any case, we added November’s HFRI returns to the scatter plots we showed you back in October. As you can see from the charts below most strategies returned approximately what you might guess using a simple linear regression of monthly returns since January 1990 (shown by the black lines in the charts below).

We start with equity market neutral since this prototypical hedge fund strategy had been holding-up very well over the past year. (Note: The HFRI is a “fund weighted” index of 2,000 constituents. So even when the Madoff feeder fund returns are updated (if they haven’t been already), the index won’t change that much.)

Like the Equity Market Neutral sub-index, the HFRI Composite Index was also in line with long-term results in both October and November.

However, the HFRI Relative Value Index continued to under perform long-term results.

Similarly, the HFRI Event Driven Index underwhelmed in all three months…

But the HFRI Global Macro Index continued to shine – out performing a linear regression in all months…

Many will say that simply losing *less *than the market flies in the face of the hedge fund “promise” of absolute returns. But as author Alexander Ineichen has argued, such *asymmetric *returns are the real promise of alternative investments.