When people use the term “Alternative Investments”, they generally refer to hedge funds and private equity. A hedge fund is loosely defined as a pooled vehicle which purports to deliver returns which do not follow the traditional asset classes such as stocks or bonds. Unfortunately, we saw in 2008 steep declines in stocks accompanied by steep declines in the returns of many hedge funds. In other words, the primary appeal of hedge funds – that they are truly hedge funds – was not realised by a large part of the hedge fund universe.
This experience has resulted in an ongoing debate regarding the nature of “alpha.” Some funds and commentators argue that if the S&P 500 Index was down 37% in 2008, and a hedge fund down only 22%, the fund outperformed its benchmark, thereby generating alpha. Being down 22% is mediocre performance – and we see the chaotic environment of 2008 as an outstanding opportunity to identify true “hedge” funds and true alpha. Merely beating the benchmark does not mean that a fund generates alpha. Good investors are committed to investing in hedge funds that have proven the ability to perform in down markets and 2008 performance can be a very useful tool in their toolbox.
How do you find Alpha?
Investors in hedge funds can borrow an important lesson from Warren Buffett. A core tenet of Buffett’s investment philosophy is finding companies that have generated high earnings in the past, coupled with reasons to believe that performance will continue in the future. While Buffett looks for things like established brand names or inherent economic advantages to project the past into the future, insightful hedge fund investors can evaluate whether the conditions that generated superior performance in the past are still in place. The fundamental question is the same as Buffett’s: Can we assume that this past performance will be repeated? That inquiry leads to questions such as: Have any key personnel of the investment team changed? Has the fund’s strategy changed materially? Has AUM risen materially? It is not enough to simply note that a fund has generated alpha in the past. The critical question is whether it will recur in the future. The past is a guide, but only that.
Our fundamental investment tenet is finding established but repeatable alpha that can withstand changes in market conditions and very poor market conditions. A good manager – in the right strategy – should be able to perform in nearly any type of market and both strategy and manager decisions should be aimed at repeatable performance. We also must take note of the historical performance and risk-reward metrics of various strategies. Over time, the strategies that have performed the best are global macro, event driven, and long/short equity, and those are ripe areas to find true alpha and true “hedge” funds.
Here are five important things to look for (“5 Up”), and to avoid (“5 Down”), when choosing a fund.
1. Any fund which realised positive or flat returns during the year 2008. A fund that excelled when the market crashed is one that has something unique about it.
2. A replicable process for investment selection. The market cannot be controlled, but an investment philosophy can. One year of strong performance is useless. It’s a marathon, not a sprint; you need to see that a manager knows how to repeat good results.
A good manager:
a. Sources ideas from a broad universe of investment possibilities, and has a repeatable process for expanding this opportunity set
b. Uniformly employs a set of quantitative or qualitative variables to evaluate opportunities
c. Uses some type of disciplined method for knowing when to exit positions
3. The ability to overcome the unexpected. Many hedge fund managers are good at making bets on the future. Let’s say that a manager predicts that 2011 will be a bear market and he sells down to cash, and the market does in fact crash in 2011. This prediction reflects a good market sense but does not indicate a skill in overcoming the unexpected. Every manager inevitably will be confronted by situations he cannot control that move against him. A question we almost always ask of a manager is what she would do if the opposite of her prediction started to come true. Managers need to be nimble as well as intelligent.
4. Efficient operations. If your financial planner is your family physician, your hedge fund manager is your surgeon. You want to get the sense that the hedge fund runs its office like an emergency room. There should be plans for all contingencies.
5. Historical performance that makes sense. A fund outperforming when others failed is a great standout, but you can’t judge a book by its cover. Many hedge funds inflate or misrepresent performance, because valuation policies and practices are unique to each fund. One way to test a track record is to take one month of the firm’s financial statements and construct a return which matches the one that is being stated. If you can’t come up with the same number, there may be funny maths going on.
1. Discretionary marking and valuation of positions. Valuation procedures can vary by strategy. You could value many long/short equity managers’ portfolios by using publicly available information from Yahoo. However, managers have more discretion over their performance when they trade less liquid securities. Taking careful note of the fund’s valuation policy, the liquidity of the assets in its portfolio, and the fund’s discretion in the valuation process are indispensable parts of the hedge fund investment process.
2. Signs of incompetence during interview. A world-class hedge fund manager should be willing and able to talk about his investment philosophy, how he generates returns, which environments are good, which are bad, and any other intelligent question about his investment acumen. Manager willingness and ability to talk at length about these things should be a key component of a scoring system.
3. Change of strategy. Hedge funds are paid to be niche specialists in a particular area. Radical change may portend a manager travelling to unfamiliar waters. Even the smartest of all convertible arbitrage managers, for example, must be considered novice if suddenly switching to a managed futures trading strategy.
4. Failure to produce routine documentation within 48 hours of request. There is no good excuse for a fund to fail to send you their updated compliance manual, offering memorandum, etc, immediately. Be sure to date your notes when you request documentation, and note any laggards. Would you be happy if you requested your financial statements from this fund, and you had to wait for more than two days? Such lags indicate operational inefficiency.
5. Historical returns that do not warrant the fees paid. Here we circle back to our original question: “What is alpha?” We do not want to pay performance fees on performance that simply mimics movements in the benchmarks – or “beta.” Hedge funds exist to generate alpha, and investors should pay only for alpha. It is also important to double check the fund’s calculations of important performance metrics such as the Sharpe Ratio and Sortino Ratio.
True alpha producing hedge funds remain very appealing investment vehicles, but it takes effort and expertise to unlock their potential.
The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak. This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein. An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk. An investor in hedge funds could lose all or a substantial amount of his or her investment.
Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information. Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.
This document is neither advice nor a recommendation to enter into any transaction with Diamond Oak or any hedge fund or other investment. This presentation and its contents are proprietary information of Diamond Oak and may not be reproduced or otherwise disseminated in whole or in part without Diamond Oak’s consent.
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