Hedge Funds Returns Part 3: Dealing with Funds and Benchmarks Selection

by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin

You may find Part 1: Measuring What here, Part 2: Dealing with Biases here and Part 4: To higher moments and beyond here.

As maintained throughout this series of posts1, comparative returns computed across asset classes often suffer from a host of computational biases. The core CFA Alternative Investment and Investment Theory modules across all levels of CFA body of knowledge attempts to address some of these problems and biases, but many remain outside the daily toolkit of the analysts.

Several of the biases involving assessment of the hedge funds’ performance are well known. These include the survivorship bias and reporting bias.

In the former case, all benchmarks used in assessment commonly exclude assets that have either gone off the market or are removed from the benchmark calculation due to sustained relative underperformance (e.g. equities that no longer qualify for index inclusion or funds that no longer trade). If you are invested in traditional index funds, your survivorship bias as well as index composition bias should be controlled for. Both, aggregate hedge fund indices and equity funds’ performance metrics suffer from these. As a result, from the investor perspective, simple benchmark comparatives become rather complicated and sensitive to data sample and time horizon of assessment.

In the latter case, applicable primarily to the hedge funds and other funds, where reporting is not required by law, aggregate indices may not be representative of the true returns across the sector, even after we control for exits of funds. Such biases can severely distort information content and returns forecasting, as noted, for example, in Cooper and Li (2012).2 Furthermore, such biases are frequently found to have an asymmetrically larger impact on reported returns and risk metrics for the hedge funds as opposed to other asset classes.3

Beyond data biases rest more traditional anomalies. For example, assessing funds’ returns against equity and fixed income benchmarks, one has to take into account different tax and cost exposures associated with different asset classes.

In fact, higher fees charged by the hedge funds compared to other funds, such as ETFs and mutual funds, can be a sign of investors’ irrationality. Still, the same evidence can also be a signal of hedge funds’ value-added in a diversified portfolio. Lajbcygier and Rich (2014) looked at the hedge funds’ fee structure in an attempt to identify a signal of hedge fund performance. They found “little support for the notion that high incentive fee funds generate superior risk-adjusted returns during normal market conditions”.4 Instead, the authors identified evidence that “increases in incentive fee level are accompanied by an increased proclivity to take on risk and increased leverage. Consequently, higher incentive fee funds suffer higher rates of attrition.” More leverage, higher risk in individual positions, more volatility-prone strategies seem to be associated with the funds having ‘more skin in the game’. However, “higher incentive fee funds do demonstrate lower market correlations and thus provide enhanced diversification benefits. As a result, high fee funds exhibited remarkable out-performance during the recent global financial crisis”.

These findings are interesting. We know from other literature that funds managed on the foot of the manager-specific strategies and funds with less transparent strategies overall tend to generate returns closely aligned with the manager-specific characteristics (such as propensity to take risk). It seems that a large number of hedge funds fall into the same category: the gamblers’ own traits are transmitted to fund’s bets and, thus, to investors’ portfolios. As long as investors in a hedge fund differ from hedge fund’s manager, the investors may be willing to pay a premium to introduce a strategy variation into their portfolio that is idiosyncratically distinct from the their own investment style.

We can call it behavioural biases diversification (reducing the weight of investor-own biases in her portfolio), but we might as well call it a hedge return to holding a hedge fund. Or, if you prefer a more simple explanation – willingness to pay more to reduce our own reflection in our portfolios.

Resources: Social Science Research Network and CFA Institute.

References

1. Hedge Funds’ Returns: An Alternative Investment or An Alternative to Investment? Part 1: Measuring What? and Part 2: Dealing with Biases.

2. Cooper, Ricky Alyn and Li, Tingting, “Absolute Return Equity Risk Attribution and Forecasting”, December 31, 2012. Journal of Performance Measurement, Vol 17, No 2, Winter 2013

3. For example, see Burton G. Malkiel and Atanu Saha “Hedge Funds: Risk and Return” Financial Analysts Journal, November 2005, Vol. 61, No. 6

4. Lajbcygier, Paul and Rich, Joe, “Do Incentive Fees Signal Skill? Evidence from the hedge fund industry”, July 1, 2014

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