November (Pre-Madoff) HF returns were just getting back on line

Dec 17th, 2008 | Filed under: Editor's Pick, Today's Post | By:
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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?


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