Most investment mistakes are made by chasing past performance.
There is nothing wrong with studying a fund’s 1-year, 3-year, or 5-year return.
However, the disclaimer that “past performance is not a guarantee of future results” has become merely white noise for most investors.
Investors who start and end their analysis by treating past performance as the roadmap for how a fund will perform in the future tends to shortchange themselves in terms of due diligence – their capital might be better deployed elsewhere.
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Hedge fund performance analysis is a joke
Rob Isbitt’s writeup in Forbes does an excellent job of making the case for why hedge fund performance analysis is a joke; and that “investors ought to do their homework, look beyond past performance, and identify with the investment process of the investment program.”
Salient takeaways from his article:
- When viewing a Top 100 list, “the investment public will do what it usually does: treat any list of top performers over some static time period as a rationale for blocking out every facet of a professionally-managed investment portfolio, except for past performance.”
- “Investing is not about return, it is about the balance of return and the risk taken to earn that return.”
- “The last thing I looked at was past performance. Getting mesmerized by eye-popping return figures ignores the conditions under which those returns were produced.”
- “Hedged investing is more than meets the eye and can play a helpful role within an overall investment allocation.”
Isbitt’s conclusion is that hedge fund do have a place in an accredited investor’s portfolio. However, it often takes more effort to “pierce the veil” and understand a fund’s investment philosophy than what most investors are game for.
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Why so complicated
Broadly speaking, hedge funds aim to deliver risk-adjusted return.
Risk-adjusted return is the investment philosophy that views return as not absolute but a balance of return vs the risk needed to earn that return.
This is contrary to what majority of investors zoom in on: Absolute return. aka How much money might the fund make for me? Without doing the heavy lifting of understanding the fund’s inherent return-to-risk ratio.
For the informed investor, going the extra mile to adopt the lens of risk-adjusted return, hedge funds play a complementary and specific role in an investment portfolio: To deliver risk-adjusted return relative to other holdings.
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But hedge funds have a bad rep
Indeed. The love-to-hate persona of hedge funds and private pools of money, most recently embodied by Melvin Capital and the Archegos family office blowup, served to fuel the industry’s negative image.
Keep in mind that hedge fund is an extremely broad, all-compassing category.
There are numerous styles of investment strategies. And to make it even more confusing, there is no standard way of classifying and quantifying hedge funds.
Based on investors voting with their dollars, hedge funds must continue to be doing some things right.
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Keep it real: Do hedge funds deliver?
The answer is… complicated.
This FT article (Jan 23, 2021; subscription paywall) notes that picking hedge fund winners is increasingly tough for investors. One of the takeaways:
“Far more than in most years, being in the right place at exactly the right time in 2020 really determined a manager’s fortunes, rather than an ability to dissect a balance sheet and build a pricing model. Hence more than ever, recent past performance is unlikely to be a reliable indicator of future returns.”
In addition, in 2020, the chasm between hedge fund winners and losers (FT subscription paywall) hit its widest level since 2009.
- The winners: Caxton made a record 40 percent gain while Brevan Howard gained 24 percent; Mandarin Offshore fund returned almost 28 percent; and Skye Global gained 63.8 percent.
- The losers: Billionaire Michael Hintze suffered 36 percent; Winton Group fell 22 percent; and Renaissance Technologies Institutional Diversified Alpha fund dropped 33.3 percent.
One way to think it: Clarity of one’s investment mandate is proportional to one’s expected hedge fund performance.
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What is an investor to do (with hedge funds)?
Understand why hedge fund
Hedge funds are not for everyone. This is not a knock against the democratization of investing nor restricting access to sophisticated instruments for the masses.
Adhering to regulations, hedge funds are offered only to accredited investors (individuals and institutions).
Pointedly, hedge funds serve a specific purpose in a portfolio. Taking up 10 to 20 percent of capital allocation, hedge funds are labeled as liquid alternates because they complement other traditional holdings: stocks/bonds and illiquid investments including PE/VC, real estate, and pre-IPO.
Informed investors seek out hedge funds as a source of alpha diversification.
In fact, hedge funds were legitimized in part by the late David Swensen as a worthy source of risk-adjusted return.
It was Swensen, the pre-eminent investment officer of the Yale Endowment, who unleashed a revolution by allocating endowment money into “alternative” investments, including hedge funds, and thus brought wider acceptance to hedge fund investing by institutional investors.
Look beyond past performance
Study past performance as you would backtest results – as a starting point and window to question a fund’s investment philosophy and mandate.
Recognize and dampen the desire to make an investment decision based solely on a fund’s past performance.
If one has not previously invested in the fund, keep in mind that past performance has done nothing for your capital. Hence, give past performance a similarly low-level weight in your analysis.
Due diligence questions to ask
Look beyond the simple, singular metrics of past performance to ask these select questions (credit to Marc Van de Walle, Bank of Singapore, for this frame):
Quantitative
- What was the level of risk the manager took to generate returns?
- Have these returns been consistent with broad-based contributions across the portfolio (instead of a few “big bets”)?
- How has the manager been able to perform and navigate risk during times of market stress?
- Explain the portfolio’s approach to outperformance and resilience.
Qualitative
- People – Who are the fund managers and other key staff who run the fund? Are they reliable, and what kind of people are they?
- Investment Philosophy – How do the fund managers approach investing? What drives the thinking behind the investment?
- Investment Process – How does the fund manager find good assets to invest in? What is the process that generates the investment thesis, selection of assets and execution of the strategy?
- Portfolio Construction, with particular attention paid to quality and consistency – How does the fund manager create a portfolio, what does he/she/they pay attention to? What is the frequency of trading and costs?
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Conclusion
A study of past performance is the ground floor of an investment due diligence process.
Informed investors seeking the higher-levels of investment strategies that deliver risk-adjusted returns will do well to understand a hedge fund’s investment philosophy and place in their portfolio; and go the distance to ask the right questions of the fund.
A study by NYU Stern Professor Finance Stephen Brown notes:
“Diversified hedge fund strategies, whether self-managed or through a fund of hedge funds, do have favourable returns per unit risk that they undertake and thus have a place in a well-diversified asset portfolio.”
In summary, a tangible question most investors should be asking themselves isn’t “why hedge funds” but rather “what is the best way to invest into hedge funds?”
