Over time, the somewhat arbitrary selection of the calendar year as a performance fee window has raised the hackles of some hedge fund investors.  Some argue that a year is too short a time and performance fees should be calculated - or at least paid out - only after several years.

While a longer performance fee calculation period seems to make perfect sense (it would reduce the “asymmetry” where the manager who can win but can’t lose), a new research study reveals one potential drawback of such a system.

In “Locking in the profits or putting it all on black?” Andrew Clare and Nick Motson of the Cass Business School examine whether hedge fund managers reduce risk at the end of a year when they are likely to receive a performance fee and whether managers “put it all on black” toward the end of years when they are not yet in performance fee territory.

More…

Regular readers may recall a back-of-the-envelope analysis of hedge fund index dispersion that we ran a few months ago.  We found that there was a significant range in the July returns across data from different index providers.  This dispersion was modest at the composite level, but was quite significant at the sub-strategy level.

The thumbnail chart at the left contains the two standard deviation ranges of various sub-strategy indexes (one standard deviation on either side of the mean across an average of about 8 index providers per index).  If you click on the thumbnail, you’ll see that the highly diversified funds of funds and composite indexes tend to have a minimal dispersion.  However, there was significantly less commonality between the equity market neutral, managed futures, short-bias, and event-driven indexes reported that month.

While November’s results begin to roll in, we ran the same test again on October’s returns (which have all now been fully reported by the providers we track).  With the absolute value of returns significantly larger in October, one might expect the ranges to be commensuratley larger.  As you can see by the chart below, this was largely true (note that we had to set the grid lines at 5% vs. only 1% for July):

In fact, the average standard deviation across all sub-strategy indexes was up 3.5x in October (vs. July).  The standard deviation of Convertible Arbitrage indexes went from 0.44% in July to 3.58% in October, an increase of over 8x.  Oddly, the standard deviation of Equity Market Neutral indexes was actually down in October (from 2.82% in July to 1.12% in October).  In other words, there was more “agreement” between the index providers in October than there was in July.

When you rank the sub-strategies from smallest dispersion to greatest, you can see that the order has also changed.  Notably, Event-Driven went from near the bottom to the very top of the list.  In other words, most databases reported similar results for this segment in October.  Fluke or a common “event-driven” factor in October?  Who knows?

Studies have shown than a very small proportion of the world’s hedge funds actually report to 5 or more databases.  So it comes as no surprise that index returns differ across providers.  As a result, you can’t really interpret any single index as a true representation of a sub-strategy’s performance.  Unfortunately, this problem seems to be compounded by the fact that the level of alignment between providers is very dynamic on a sub-strategy basis.

With hedge fund redemption gates now being shut with increasing frequency, it has become vogue to question the ethics, if not the very legality, of “not giving investors their money back.”  But holding onto investors’ capital - assuming such a possibility is included in the fund’s O.M. - is actually neither bad nor good on its own.  In fact, this illiquidity might actually have a fair market price according to a Swiss study.

After all, when a bank takes a term deposit, investors don’t get their money back for several years.  Yet few people complain that these guaranteed investment instruments won’t give investors their money back.  Instead, they simply demand (and receive) a higher return from these illiquid instruments.

A hedge fund O.M. with an optional redemption gate clause is analogous to a hybrid between a term deposit and a more liquid demand deposit.  The price an investor should be willing to pay for that fund (or put another way, the return they should expect from it) should therefore reflect the possibility of the “demand deposit” essentially becoming a “term deposit”.

Although the likelihood of the manager shutting a redemption gate is a function of the size of investors’ redemption requests, the illiquidity of many hedge fund portfolios makes them more exposed to possible gate closures than more liquid traditional portfolios.

The question many investors are now asking themselves is “so how much of my hedge fund’s return was simply a fair compensation for that illiquidity?” Several AllAboutAlpha.com guest contributors have wondered the same thing (Ranjan Bhaduri, AlphaMetrix; Pierre Laroche, Innocap; Konstantine Danilov, Bank of America).

Now Rajna Gibson and Songtao Wang of the Swiss Finance Institute join them by exploring how much of hedge funds’ alpha is actually just a fair compensation for taking on this illiquidity risk.

More…

This bad…

The following series of scatter plots are based on data from Hedge Fund Research.  As you can see, the urban legend that hedge funds “deliver absolute returns in good times and bad” was clearly never supported by the historical evidence.  The following chart stacks the broadest index available, the HFRI Fund-Weighted Composite, against the monthly S&P 500 returns (since January 1990).  The black line is the linear regression (the slope of which is the beta of the index vs. the S&P 500) and the red circle is September 2008.

While this index includes around 10,000 funds, a look below the surface at different sectors reveals some interesting trends.  For example, about a third of this composite index is made up of the “Equity Hedge” category…

This index performed even worst last month than the broad composite.  While September was clearly out of line with historical returns, the lion’s share (around three quarters) of this category is made up of “Fundamental Value” sub-strategy defined as being decidedly long-bias:

“…typically focus(ing) on equities which currently generate high cash flow, but trade at discounted valuation multiples, possibly as a result of limited anticipated growth prospects or generally out of favor conditions.”

To many, so-called “Market Neutral” funds are the prototypical hedge fund.  While these funds only comprise a small portion of the constituents in the index, they stayed true to their name for most of their history - until September…

Thankfully, market neutral funds seem to be back to their neutral ways in October.  Several weekly indexes are now showing them to be roughly flat so far this month (while other strategies continue to suffer).

The real winner (if you can call it that) was the “Macro” category. Those funds logged a narrow loss for the month, but actually beat what a linear regression suggests they should have delivered.

While September was bad for most categories, nowhere was the draw down as pronounced as in the “Relative Value” group.  These funds pursue fixed income and volatility strategies.  Multi-strategy funds are also included in here:

September’s data points stick out like a bump on a log.  And by mid-month, October was looking equally grim for many of them.  So that lonely blue dot may have some company pretty soon.  Stay tuned.

While investment managers have been the primary advocates of performance-based fees, there is little doubt that institutional investors have given their tacit approval to them on the basis that they align the interests of manager and client.  These institutions look particularly smart when their manager hits a rough patch (see Friday’s post).

A recent study by accounting firm Grant Thornton points to lower fees as a major incentive to shift to a performance fee arrangement:

“Assets under management and total fees had reduced dramatically from 2000 to 2003…Boards, in turn, saw performance fees as attractive since, depending on their structure, they could reduce total expense ratios in difficult times such as those that they had recently experienced.  (Generally, when a performance fee is introduced, the basic management fee is adjusted downwards, thereby reducing total fees in a period when a performance fee is not earned.)”

The study goes on to list a variety of different possible aspects of a performance fee contract:

More…

Granted, it took a future Nobel Laureate to invent the Sharpe ratio.  Yet this handy measure has achieved unprecedented ubiquity largely because of its simplicity and ease of use, not necessarily its robustness.

The Sharpe ratio assumes that returns are symmetrical and bell-shaped - that the chance of winning is the same as the chance of losing and that these chances are easily predictable if you know the standard deviation.  But since hedge funds tend to invest in things that have asymmetrical returns (options, for example), their own returns are often skewed to the positive or negative.  Furthermore, these exotic instruments tend to increase the chances of both winning and losing even though the standard deviation of the fund may not change at all.

Given this, you’d think that better measures of hedge fund performance exist somewhere out there.  In fact, we’ve written about several candidates on these pages.  But a study by Martin Eling of the University of St. Gallen and Frank Schuhmacher of the University of Applied Sciences and Technology Aachen suggests that such a search might actually be in vain.  In fact, the duo say the choice of performance measure doesn’t actually influence the relative ranking of hedge funds much at all.  (They extend their research into the world of mutual funds in the May/June 2008 issue of the Financial Analysts Journal.)

More…

With the proliferation of hedge fund indices these days, it can be tough to figure out which provider to trust sometimes.  Around a dozen managers of hedge fund databases pump out returns across various hedge fund strategies each month.  But invariably, the numbers seem to differ.  Curious about these differences, we did a little back of the envelope study today that we share with you below. 

We looked at July’s hedge fund index returns from Barclay Hedge Fund Indices from: CASAM, CogentHedge, Credit Suisse/Tremont, Dow Jones, Edhec, Eurekahedge, FTSE, Greenwich, HedgeFund.Net, HedgeWeb.Net, Hennessee Group, HFR, MSCI, and RBC.  Specifically, we wondered if the returns reported for each strategy had different levels of dispersion.  You’d think that the larger the average sample size in each database, the smaller the dispersion of returns.  Further, you might guess that funds using certain strategies might tend to stick closer to the average (see Wednesday’s post). 

Below is a chart showing the 2 standard deviation range of the reported July returns from the various databases (with the sample sizes in brackets).

More…