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Hedge fund returns

Hedge fund returns ranged from -100% to +1,000% recently. A few blew up while some bet the farm and were right. Most "sophisticated" investors avoid short biased strategies so it is ironic that short only credit was the best performer. In 2008 short selling equities will likely be the best strategy. However the performance that matters is how much money was made from how much risk. One big bet or consistent returns over the long term?

The "average" return has many funds with different levels of risk and leverage and includes such a wide dispersion of performance that it's irrelevant. Hedge fund databases list many non "hedge funds" and miss lots of good hedge funds. As positive results are unbounded to the upside but losses are floored at -100% the skew from the effect of high outliers will upwardly distort the mean anyway. Also there is the much bigger issue of what kind of returns investors are seeking.

There are more one hit wonders in fund management than the music industry. Every year there will inevitably be traders that make a big bet on some idea which proves to be right. Whether they can keep on finding ideas that work and can hedge risk in case their next idea is wrong is much rarer. Some good funds had a flat to slightly negative year while some lucky funds had enormous returns but one year counts for little. A manager that makes +15% CAGR over 15 years is much more impressive than one that makes +1,000% in 1 year.

Alpha or beta? The purpose of a hedge fund is surely to offer a source of performance NOT obtainable from a traditional fund. This would imply that the "performance" to measure is the risk-adjusted true alpha that a manager extracted from their opportunity set. The idiosyncratic returns contributed over and above what the underlying factors added. If you do this you get a very different ranking of performance results than what the headlines suggest. It is the QUALITY of the returns that matters not only the QUANTITY.

Obviously I favor hedge funds but many of the concerns critics raise on general hedge fund industry issues ARE legitimate. For asset allocation unhedged traditional funds have lower fees, lower due diligence costs and more liquidity and transparency but they do little to mitigate risk. IF a return source can be accessed through a traditional product that is the way to go. The reason to invest in ANY hedge fund is if it can produce a risk-adjusted return that would NOT have been otherwise available.

Unfortunately many products purporting to be hedge funds are dependent on the underlying asset class going up. Credit, until very recently, and currently Asian/Latin American stock markets are examples. Many energy hedge funds have ridden energy beta this year. Too often leveraged beta gets disguised as alpha. It is also easy to appear uncorrelated but be beta dependent. Many of the basic high school linear statistical measures are useless. A high volatility equity can have zero beta. A low volatility fund can have enormous risk. A low correlated fund can be 100% dependent on the underlying but conversely a fund with a correlation of 1 can STILL be a valuable diversifier!

A high volatility hedge fund can be low risk and REDUCE the volatility in a portfolio. Some of the riskiest strategies in isolation have the opposite function in that they lessen total portfolio risk. This rather nullifies the performance statistics hedge funds and funds of hedge funds email out to investors each month. Mean variance optimization isn't very useful in hedge fund portfolio construction when averages, variances and covariances are either useless or, worse, misleading.

HOW the return was made can be more important than WHAT the return was. If you are SURE the stock market is going up next year you probably do NOT need any hedge funds in your portfolio. If you think oil, gold, Chinese real estate or anything else is going up there are better ways to implement that view than a hedge fund. But if you want exposure to the opportunities created by the mispricing and anomalies in and between asset classes, ESPECIALLY if the asset class goes down, then that is the main reason to invest in a hedge fund. Most investors already have enough exposure to economic growth and long only.

"Hedge funds" apparently outperformed "equities" in 2007. But hedge funds are supposed to offer an alternative source of return. How equities or any other asset class performs is irrelevant. Hedge funds are strategy classes. And which "equities" are we talking about? The MSCI World index is not very worldly anyway. Compared to Chinese indices "average" hedge fund returns have been pathetic; compared to Japanese indices "average" hedge fund returns have been brilliant. So what? Whether a hedge fund underperforms or outperforms any asset is of no importance; it is the DIFFERENT performance that matters.

I've written before that most of the -100% funds this year were not hedge funds anyway. That was clear to me years before they imploded. But non-hedge funds marketing themselves as hedge funds cuts both ways. Several of the funds that made +100% this year were also NOT hedge funds. What amounts to leveraged long only equities, commodities or other assets is not a hedge fund strategy even if there is supposedly a modicum of shorting or hedging going on. Making money when the underlying rises and losing money when the underlying falls is a closet INDEX fund not a hedge fund. Why pay hedge fund fees for performance obtainable elsewhere? No-one makes money all the time of course but losing money is better when other things in the portfolio are making money.

Emerging markets have been the best "performer" this year though comparatively few "hedge funds" operating in the space actually are hedge funds. Much of the returns have been driven by beta. If a manager can't make money in the absence of beta then it is not a hedge fund. If you think China, India or Brazil equities are going up buy ETFs like FXI, INP and EWZ or some other long only product. There is no logical reason to pay 2 and 20. I've met several Indian and Brazilian funds recently and usually ask them how they would have done if the BSE or BOVESPA were down 50%. The good ones would still make money or at least preserve capital in that scenario. Not the bad ones though...

At the moment everyone loves Chinese and Indian hedge funds and hates Japan focused hedge funds. Obviously the headline absolute performance is vastly higher with many of the former up over 100% while many of the latter are up less than 10% or even negative. But if you compare their alphas as I define alpha: observed return minus expected return generated from their security universe adjusted for exposure and risk so the "performance" of a +10% Japan hedge fund could be argued to be superior to a +100% China hedge fund.

Alpha is surely what has been generated from a particular opportunity set adjusted to reflect the risks. A USA fund that makes 20% picking S&P 500 stocks has probably done a better job than a fund that makes 30% picking obscure microcaps. A Germany long short fund that produces 20% has likely done better than a Russia fund up 40%. If a fund sets up to invest in art, violins or uranium then it must demonstrate how it will STILL make money when art, violins or uranium go down. The are many "niche" strategies knocking around these days that use the hedge fund label to be trendy and charge fees more than they are worth but have little to do with hedge funds.

There have also been lots of portable alpha mandates recently. But these are only of value if it really is alpha NOT with plenty of beta mixed in. Asset allocation overlayed with strategy allocation is impossible if it just adds more beta to the portfolio INSTEAD of adding alpha. Strategy allocation should be about strategies that can perform when long only does not.

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