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Browse by CategoryHome » Category List » Analytics & Metrics
Short positions throwing a wrench in the works for traditional (long-only) institutional investors17 July 2008
We stumbled across this article by BNY Mellon’s fund administration arm that reveals some of this complexity. The paper argues in favour of a holistic approach to portfolio risk analytics - an approach not always followed by institutional investors according to the firm:
In essence, BNY Mellon is following the recommendations of Bruce Jacobs and Kenneth Levy who said in this article and others that you shouldn’t analyze a long/short portfolio as separate long and short portfolios since a combined portfolio will always be more optimal (i.e. have a higher risk/reward ratio). The authors of this article use a simple example they call the “Russell 2000 Argument” to illustrate the analytics of the same idea. They compare two rudimentary portfolios - one long the Russell 1000 and one long the Russell 3000 and short the Russell 2000 (stocks 1001-3000 of the R3000). While both funds are essentially identical from an exposure standpoint, they differ on several common measures, namely:
While this may seem kind of obvious using this simple example, you can see how these same issues can throw a hedge fund administrator or risk manager into a tizzy when things become more complex. The paper goes through a fictitious example of a market neutral fund to show how exposure figures can get wildly out of whack when the net exposure of the fund shrinks to zero (as in a market neutral fund). What was a modest negative exposure to tech and healthcare, in the example below, becomes gargantuan when compared to the funds puny net exposure.  To combat this deficiency in traditional analytical techniques, BNY Mellon essentially recommends that net exposures be calculated on a sector basis and by beta- and market cap-weighting the holdings (collectively falling under the name of “tilt” approaches). But the deficiencies in traditional fund analytics don’t end there. The traditional approach to calculating portfolio liquidity (”days trading volume held”) uses a net exposure denominator. Again, this could be a very small number for a market neutral fund - making the fund look wildly illiquid. Instead, BNY Mellon recommends that the denominator be gross exposure, not net exposure. While these issues are second nature for hedge funds themselves, they illustrate some of the challenges being faced by traditional long-only managers as they start to add on short positions in 1X0/X0 funds.
Comments »Day one from the un-named event in London2 June 2008We report today from a three-day London gathering of some of the world’s largest institutional investors and the hedge funds that serve them (see postings from sister event in Boston last fall). The event focuses not on hedge funds per se, but on how institutional investors use them (portable alpha, fees, alpha/beta separation, 130/30, alternative beta, analytics etc…all the good stuff). In order to create an open atmosphere for candid discussion, organizers have us on a tight leash (there are otherwise no media present here and we can’t even tell you the name of the event). And while we can’t really tell you who said what today, we can pass along some of the major themes from the conference floor. Here’s some of what we heard… Hedge Funds: Innovation from the garage?
Most here held the opinion that “hedge funds” was no longer a useful definition of an asset class. One panellist put it in terms of innovation. He described hedge fund companies as a “platform for innovation”. In an allusion to innovation in the technology sector, he said that “innovation usually happens in garages”, not in large corporations (a clear reference to the oft-cited garage where tech behemoth Hewlett Packard was born - pictured above). In other words, it may be difficult for a large traditional manager to deliver on the major promise of the hedge fund sector - innovation. Issues such as profit- (and risk-) sharing, for example, can often confound the efforts of long-only managers (e.g. banks – see related WSJ piece from last week) to maintain hedge fund programs over the long term.
Comments »Skeptics to hedge fund managers: Your alpha has been faked!3 April 2008
Now Wharton’s Dean Foster and Peyton Young of Oxford University and the Brookings Institution have added to the manager-as-scammer literature with a new paper entitled “The Hedge Fund Game: Incentives, Excess Returns and Piggybacking“. In it, they decry the proliferation of “fake alpha” (e.g. selling options and using the wrong benchmark to calculate alpha). The paper was published in January, but didn’t start making serious waves until mid-March when Martin Wolf, Chief Economics Commentator at the Financial Times wrote a column about it. Wolf points out the asymmetry inherent in any type of incentive fee and holds up the Foster/Peyton paper as a “beautiful” example of how incentive fees can be gamed. He says that such a structure bears a resemblance to the used car industry. Like the used car industry, he says the hedge fund industry “is bound to attract the unscrupulous and unskilled.” [Ed: We’re reminded of the famous Forbes cover story on hedge funds in May 2004 ”The Sleaziest Show on Earth“]
Comments »Alpha-centric Newsreel14 March 2008
Morgan Stanley says Alpha/Beta Separation “the way of the future”. The AllAboutAlpha site partner lays out its alpha-centric philosophy telling IPE that the pension industry is about to experience a “second wave” of LDI strategies based on the separation of alpha and beta. Dutch Insurer Aegon splits portfolio into alpha and beta segments are farms each one out to a different manager. According to the firm’s press release, “By managing the parts separately from one another, better risk-return ratios are possible. This way, more sources of value added will be available and a greater focus can be created in the portfolio. Separating the US share portfolio has created an increase of a yearly average of the total return of 2.5% without any risk increase.”
Comments »Shadwick to Quants: “Financial models should come with health warnings!”9 March 2008Regular readers may remember the name William Shadwick (see related posting). Widely known as the developer of the Omega Function and Omega Metrics®, Shadwick won the 2007 Journalism Award of the Investment Management Consultants Association ,jointly with Ana Cascon, for a paper in which they lifted the veil on some of their powerful new statistics for finance. A prominent mathematician, he was responsible for establishing the Fields Institute for Research in Mathematical Sciences before entering the finance industry in 1998. He is the founder of Omega Analysis, a quantitative research firm in London. Shadwick, who believes in using sophisticated tools and avoiding unnecessary complexity, issues a general warning about the “hidden assumptions” in quantitative models below. He has also been watching the ongoing debate between Harry Kat and Lars Jaeger and tells AllAboutAlpha, “I’m afraid it doesn’t offer much comfort to either the Jaeger or the Kat school…I think that over-modeling has had some severely negative consequences and it’s about time people started to pay more attention to the gap between theory and reality.” That’s all very well in practice, but it will never work in theory!
The title of this piece comes from a joke about a “highly qualified” financial engineer’s reaction to a well-proven trading strategy. It illustrates the tension between theory and practice that we have all seen as quantitative methods become ever more common at trading desks and in investment management. In general, the rise of quantitative tools in finance has been highly beneficial but the widespread use of models has been a decidedly mixed blessing. In science, the constant development of theories expressed as mathematical models to be tested, rejected, confirmed or refined through observation and experiment is the main source of progress in our understanding of the physical world. This process is also crucial for engineering and technology where it is the key to predicting future events and controlling them to our advantage.
Comments »Academic study: Morningstar ratings have “unintended consequence” of being “manipulation proof”2 March 2008
This likely comes as no surprise to Morningstar itself, which said in a recent press release:
While previous versions of its mutual fund rating system had “characteristics similar to those of an expected utility function” (see this paper by Sharpe in 1998), Morningstar revamped it in 2002 to include the asymmetrical utility of gains and losses experienced by investors (download PDF of the methodology).
Comments »New paper explains “muted demand” for portable alpha3 January 2008
By this standard, Larry Gorman is a name to watch. The Cal Poly professor has a unique ability to come down from the ivory tower to help the rest of us get our head around the pressing academic issues of the day - the Fundamental Law of Active Management, 1X0/X0, and the true meaning of alpha, for example. But don’t take our word for it, Gorman has been named “Most Outstanding Faculty” in the Cal Poly finance department each of the past fours years. Gorman recently teamed up with professor Robert Weigand of Washburn University to write this relatively easy to digest paper covering some of the roadblocks on the path to alpha-centric investing (called “Measuring Alpha Based Performance. Implications for Alpha Focused, Structured Products”). Warn the duo:
Comments »Fifth birthday of bull run making mutual funds look better than they are12 December 2007
The last few years have provided mutual fund investors with a unique opportunity to compare their funds to a full market cycle, not just to a bull market (where levered or growth funds are likely outperform) or a bull market (where unlevered or conservative funds are likely to outperform). The chart below shows the rolling 5 year (weekly) returns of the S&P 500 beginning in January 2005. The section of this chart shaded in blue represents the future 5-year rolling returns of the S&P 500 (not annualized) assuming - for the purposes of this argument - that the index flatlines at Tuesday’s close until the end of the decade.
Comments »November not the new August after all10 December 2007
Here’s a brief history of the past week:
Comments »An academic explanation for the disparity in hedge fund index returns9 December 2007So hedge fund indices are all over the board. But why? Displaying perfect timing, French business school and hedge fund research hot-bed Edhec just released the presentations and back-ground reports from its recent conference in London - including a July ‘07 paper entitled ”Revisiting the Limits of Hedge Fund Indices: A Comparative Approach“. Says the paper:
Regular readers may remember this illustration from the London Business School which makes the same point graphically (see related posting):
Comments »The mystery of “slightly positive results” in hedge funds and college basketball18 November 2007There has been some talk recently of hedge fund managers misreporting returns to the various voluntary databases that collect such information. According to a study by Nicolas Bollen of Vanderbilt and Veronika Pool of Indiana University, hedge fund managers show a curious propensity to have more slightly positive months than they do to have flat or slightly negative months. In fact, the study found that up to 10% of fund returns in one major database are statistically “distorted”. You don’t have to be a statistician to see it (chart below).
According to the study, hedge fund managers also seem to have smoother returns when they are performing poorly. Researchers conjecture that this is because managers have an ability to “manage earnings” and are more likely to do so when their returns stink. That way, at least they can reduce volatility and goose their Sharpe ratio even if returns are lackluster.
Comments »Separate studies conduct returns-based analyses of Renaissance and Amaranth1 October 2007
Markov studied RIEF’s August performance to understand the types of factor exposures undertaken by RIEF. He found that the need to liquidate positions at the worst possible time (an oft-cited reason for August’s mayhem) “may only be a part of the story.” But how useful is the examination of factor exposures when a fund strays unexpectedly from its typical exposures? In a separate study, Bhaswar Gupta and Hussein Kazemi fund out what, if any, information might have been gleaned from the historical return stream of Amaranth in order to predict that fund’s eventual demise. Renaissance: Over-diversified? Renaissance’s RIEF fund was undoubtedly caught up in the August run for the exit. But “the rest of the story”, according to Markov, was uncovered using his firm’s proprietary returns-based factor model. In a nutshell, he plugged RIEF’s returns into his model “in an attempt to see if some of the losses could (or should) have been anticipated.” You may recall a similar analysis conducted by Professor Ross Miller of the State University of New York at Albany on another monolithic fund, Fidelity Magellan (see posting “Magellan a Frankenfund: Professor“).
Comments »Are some hedge funds sinking or just sailing into the sunset?14 August 2007
In fact, GMO’s Jeremy Grantham got things started early last week with a prediction that “…within 5 years…up to half the hedge funds…in existence today will have simply ceased to exist.” (Grantham Says Hedge Funds, LBO Funds to Collapse) Widely-read newsletter author John Mauldin took issue with Grantham’s typically dire prediction by pointing out that this would be in keeping with the attrition rate of typical small businesses (which, of course, most hedge funds are):
Comments »The hedge fund metric that cried wolf20 May 2007
One reader who contacted us was William Shadwick, founder of Omega Analysis, a quantitative research firm based on London. Bill is known to many as the developer of the “Omega Ratio”. And along with co-author Ana Cascon, he recently won the Investment Management Consultants Association’s Journalism Award for his paper on new methods of calculating tail risk (the paper first appeared in the Journal of Investment Consulting’s Spring 2006 edition). Unfortunately, the paper is only available to JOIC subscribers. But Bill has allowed us to host Omega Analysis’ “Primer” on tail risk analysis here and also spent some time on the phone with me last week to further explain his ideas. The document introduces a new statistic Shadwick calls the “C-S Character” of a distribution. He says this measure is “vastly superior to kurtosis in dealing with the sort of data sets available from hedge fund managers.”
Comments »Mommy, Where do alphas come from?15 May 2007
Thankfully, MIT’s Andrew Lo just released a new paper entitled “Where Do Alphas Come from?: A New Measure of the Value of Active Investment Management”. In it, Lo proposes a new way of measuring alpha that addresses this age-old question (hat-tip to The Beta Brief for calling the AllAboutAlpha tip line with this one). (Lo, by the way, scored his own chapter in Peter Bernstein’s new book Capital Ideas Evolving. Much more on this book in the coming days as we wade through it here at AllAboutAlpha.com world headquarters.) Traditional (CAPM) measures of active management have relied on the extent to which a fund is correlated to its benchmark. Then in 1992, William Sharpe took this notion a step further by regressing mutual fund returns against not just a fund’s own benchmark, but against several passive indices.
Comments »Hey! Who are you saying has a ‘fat tail’?10 May 2007
Kurtosis refers to the extent to which a return distribution has “outliers”. A fund with a low kurtosis would be more pointed than the familiar bell-shaped normal distribution. With more of its returns grouped around the middle, one might be excused for thinking that such a fund is “safer” or more “predictable” than a fund with a high kurtosis (i.e. which tend to experience more severe returns on both the upside and downside). A recent Morningstar advertisement is exemplary of this common assumption. The half-page ad is titled “The Skinny on Fat Tails” and was published recently in a popular trade magazine. It contains statements about kurtosis that are technically accurate, but misleading such as:
Comments »A Closer Look at State Street’s New Hedge Fund Survey22 March 2007On Wednesday, State Street released the findings from its survey of institutional investors at October’s Global Absolute Return Congress (”Global ARC”) in Boston. The firm surveyed pensions & endowments that they say were collectively responsible for US$1trillion of assets. Unlike a similar industry survey conducted by Deutsche Bank in January, this one did not include funds of hedge funds. As regular readers may recall, we felt that aggregating data from funds of funds along with data from pensions & endowments (”end investors”) may have skewed the results. We can see some evidence of this by comparing the State Street and DB studies. In our opinion, funds of funds are more likely to be unsatisfied with hedge funds than are end investors. The DB report suggested that investors were dissatisfied with hedge funds:
Interestingly, when the same question was posed to only the end investors, the results were markedly different. Said State Street:
In fairness, States Street did find that end investors were somewhat less satisfied with the volatility and market correlation of their hedge funds. But the ”unsatisfied” numbers were all far below 50%.
Comments »Schneeweis: Monthly hedge fund data might be leading us astray14 March 2007
Since monthly data points are generally in short supply (most hedge funds have been around for less than 100 months), all available data points are usually used to calculate things like beta, volatility and, of course, alpha. But as Schneeweis points out, the composition of the S&P 500 has changed over the past 5 years. So why examine 5 years of hedge fund correlations?
Comments »EVENT: 3rd Annual Hedge Fund Performance & Risk Measurement Event19 February 2007Dates: April 17-18, 2007 “Anything worth doing is worth measuring”, they say. With so many potential ways to skin the alpha cat, it’s probably a good idea to stop by ii’s upcoming event on performance and risk measurement if you’re in town in mid-April. Says ii:
Some say that risk management leading to asymmetric returns is the primary source of hedge fund alpha. So don’t think these topics are just for your risk management people. But it’s the “performance measurement” aspect of this gathering than caught our eye at AllAboutAlpha. Performance attribution is a surprisingly complex topic that has evolved considerably in the past few years. And we believe that in the end, performance attribution is All About Alpha. And for you hedge fund replication junkies, there’s even a session entitled “Risks in Replicating Hedge Funds”. million loans 1loan home 2ndloans bank 3 54 usa loansloans after bankrupsyday loan 2nd payaffiliate loansamerican loan searchloan 5 accured interest demand percentadvantage home loans
Comments »Performance measurement for hedge funds with neural network derived benchmarks18 December 2006By: Ramin Baghai-Wadji & Stefan Klocker, Vienna University of Economics and Business Administration
Problem is, asking managers to self identify may not always be the best strategy. Managers would face a fundamental conflict as their choice might make them look like a hero or a dog. This paper was first presented in October 2006 at the Annual Meeting of the German Finance Association. It proposes a new methodology for identifying the strategies of hedge funds by grouping them together into natural clusters using a “self-organizing map” (a.k.a. “a neural network”).
Comments »The Future of Mutual Fund Ratings:17 December 2006This article in Investment News highlights the evolving nature of fund ratings. Says Investment News:
Okay, so this isn’t rocket science. But it might represent an important step forward for the archaic methodologies used to rate mutual funds. Lipper is keeping a tight lid on things:
Comments »What Exactly is “Market Neutral” Anyway?3 December 2006
Market neutral hedge fund managers will often talk about a certain amount of beta that will “work its way into” their funds. They say it’s inevitable given the large number of trades they makes and the plethora of factors they try to neutralize.
Comments »Setting The Record Straight on Style Analysis15 August 2006By: Barry Vincor, Dow Jones This interview with William Sharpe is now well over a decade old, but contains many important observations by William Sharpe himself on active management, and the differences between returns-based and composition-based analysis of index-hugging and alpha generation. Excerpts:
Comments »Asset Allocation: Management Style and Performance Measurement4 July 2006By: William Sharpe The Hedge Fund of Funds Industry, with its focus on unique strategies, manager style and style-drift owes much to this seminal paper by The Man, William Sharpe. Excerpt:
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Comments »EDHEC and EuroPerformance publish Alpha League Table4 July 2006From: HedgeWeek Newsletter
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The addition of short positions to traditional long-only portfolios adds a whole new dimension of complexity and requisite analytics. This was true for mutual funds (see 
After years of steady growth, it’s no surprise that traditional long-only money managers have been licking their chops over the potential to offer hedge funds. Meanwhile, hedge funds have been strangely attracted to the gazillions of dollars under management by the long-only managers. Today in London, managers and investors debated the relative merits, not of hedge funds and long-only funds, but of hedge fund management companies and long-only management companies. While many people can tell you the difference between a hedge fund and a traditional long-only fund, few seem to agree on the unique characteristics of each type of company.
Subscribers to our monthly email update “
Here is a sample of the news stories we didn’t get a chance to explore in detail this week. As usual, all of them can be found on the Alpha-ticker above or in the news items section of AllAboutAlpha.com (free registration may be required for a few of these).
Special to AllAboutAlpha.com by: Dr. William Shadwick, Omega Analysis
You may recall that Morningstar launched its “Star Rating” for hedge funds 
As outside observers of the academic literature surrounding alpha-centric investing, we always find it curious that the easiest-to-read, most accessible papers and presentations are usually written by some of the field’s most accomplished and technically sophisticated members. William Sharpe, Eugene Fama, Andrew Lo, Jacobs & Levy…each seems to be able to cast aside the trappings of academia and present cogent arguments in laymen’s terms.
With the recent 5th birthday of the latest bull market, it’s getting hard to find a mutual fund that hasn’t produced great 5-year returns. Apparently this fact is not lost on Morningstar, which is 
Well it happened again - big time. The widely quoted “HFRI” index of hedge funds smoked the less-quoted, but more timely investable version, the “HFRX”. Last week we wrote that the HFRX beat the HFRI regularly - but particularly when both indices were down on the month. Well, true to form, both indices were down in November, and the HFRI beat the HFRX by 100 basis points (1.4% vs. 2.4%). Kind of takes the air out of the “November is the new August” storyline. But there are always some 
Michael Markov, CEO of Markov Processes International says that the Law of Large Numbers was the “last great gift of the Renaissance”. In a twist of irony, says Markov, the Law of Large Numbers also explains why “a simple combination of factors can mimic the performance of a large and well-known hedge fund”. That fund? Renaissance Technology’s $25 billion “Renaissance Institutional Equities Fund” (RIEF).
With a traffic jam of potential hedge fund blow-ups developing in Greater Hedgistan (mainly among the large quant funds), we are sure to hear a lot in the coming months about the “high failure rate” of hedge funds in general. 
Our previous posting on kurtosis seems to have generated considerable interest. Who knew that ‘fat tails’ could be so popular?
Ah, the question every parent dreads. Where do alphas come from? How can you possibly explain such a complex and miraculous process that has given life to asset managers since time began?
Aside from being a wonderful source of sophomoric humour about bizarre medical conditions, “kurtosis” is also a useful way of mathematically describing what many people say will be the downfall of hedge funds - their performance during “extreme events”. But unfortunately, kurtosis (a.k.a. “fat tails”) is entering the mainstream as a poorly understood measure. 
Thomas Schneeweis is an academic. So he views the primary benefits of managed accounts not as operational, but as analytical. He argues that daily and weekly return data (usually only available via a managed account) is superior to the more common monthly data used in the hedge fund industry. Schneeweis tells All About Alpha that monthly data hides all sorts of things from, for example, volatility during the last week of every month, to a high correlation to intra-month shocks. (Ross Miller of SUNY Albany shows the power of daily data in his 
Assuming hedge fund beta exists, determining the amount of alpha produced by a manager requires one to know what particular hedge fund beta a manager is leveraging. So the identification of a hedge fund as being say, ”merger arb” or “distressed” is critical in determining value added by the manager.
Naturally, the main attraction of market neutral funds is that their performance is not correlated with markets. But usually the term “market neutral” refers to the current positions held in the fund, not its actual performance vs. markets. The aggregate beta-weighted exposure of a hedge fund is rarely the same as the eventual market beta of the fund’s track record. In fact, these numbers are usually quite different. Paying too much attention to the holdings in the portfolio at the expense of the fund’s overall performance is like missing the proverbial forest for the trees.
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