Sunday, June 5, 2011

In the Hedge Fund Shadows

One of the ways that I try to give back to a society that has been very good to me and to my family is to volunteer at six non-profits. Often I sit on or chair investment and/or finance committees. In a few of these cases the committees have chosen to use hedge funds and separate accounts as well as mutual funds for their investing. During periods of volatility, often on the down side, there is considerable anxiety until the comprehensive monthly performance report is published.* There is fear that the results will be so poor that the committee will be criticized for not being on top of the portfolio deterioration that might have commanded some selling action. Most of the time one or more of the hedge funds is the last to disclose its performance, which holds up the report.

Back of the envelope

Trained as an analyst, I am often in the uncomfortable situation of not having complete and accurate inputs. What I attempt to do is to produce an educated guess as to the missing numbers. One approach, which goes back to being a scout or perhaps learned in physics or math class, was to measure shadows. In the classic experiment, if one could measure the size of a shadow and how far it was from the source of light, one could triangulate and determine the size of the object that was throwing the shadow. I use the same approach to guess the likely performance of a hedge fund.

This is not a commercial

My old firm, now known as Lipper, Inc, publishes daily, weekly and monthly performance records of almost all mutual funds in the world. While I have no financial relationship with the company, I am a user of its data for my commercial and volunteer investment advisory work. As a carry-over from when I was running the firm, it produces many investment objective indices of typically the 30 largest individual funds in each group. Since my sale of the operating assets of the firm to Reuters (now Thomson Reuters), there have been waves of “retail-ization” of hedge funds. To counteract some real and potentially large losses of mutual fund sales, various firms have produced funds that somewhat copy the techniques of hedge funds. At the moment, with new investment objectives tracking these funds, we must use their performance averages as substitutes for indices that do not exist. (For the purists in the community I would be happy to discuss the advantages of indices over averages).

What do the averages portray?

First there are four such new investment objectives that are titled: Absolute Return funds, Dedicated Short funds, Equity Leverage funds, and Equity Market Neutral funds. Second, in most cases, these are equity funds, and often their “shorting” is by selling short ETFs (Exchange Traded Funds). Third, their average expense ratios are between 1.52% and 1.73% before any performance fees, if earned. Fourth, they are somewhat constrained in their use of leverage by the Investment Company Act of 1940, as amended from time to time. This potential difference with the more unconstrained private hedge funds is one of the reasons that I use the mutual fund results only as an early indicator of what some hedge funds might produce. A tighter fit is possible by picking out specific mutual funds as a somewhat peer comparison with specific hedge funds.

The results

The average returns for the first 5 months of 2011 were:
  • Absolute Return mutual funds: gained +1.20%
  • Dedicated Short funds: lost -9.79%
  • Equity Leveraged funds: gained +6.51%, (the best of the four new objectives)
  • Equity Market Neutral funds: gained +1.02%

To put these results in perspective:
  • S&P500 Index funds: gained +5.00%
  • Multi-Cap Growth funds: gained +6.02%
  • Multi-Cap Value funds: gained +5.78%
  • Multi-Cap Core funds: gained +5.54%
  • Large-Cap funds, on average, produced returns in the +4.6 to +4.75 range

Working conclusions

When the hedge fund numbers come out they are likely to be behind the publicly available mutual fund results. However, I expect there will be some spectacularly good results. The winners will possess great selectivity skills and may have used the greater flexibility that hedge funds have to their distinct advantage. I believe that performance numbers do not provide the answers to selecting investments for the future. Performance numbers should promote questions not answers. For example, if a portfolio has significant investments in financial services stocks, one should take into consideration that the average Financial Services (domestic) fund was down -2.74% year-to-date. Around the world banks and non-life insurance companies have been the worst investment group thus far in 2011. Part of the problem for these institutions is that for regulatory capital requirements they are being forced to own too much of their own government paper in addition to holding prior bad loans to other governments. At the moment the investing public, outside of speculating on a few IPOs, is not actively participating in the market place. [Disclosure item: I manage a private financial services fund that is only appropriate for long-term oriented accredited investors who believe in looking for depressed securities.]

*My good friend Larry Goldman, the CEO of the NJ Center for the Performing Arts (NJPAC), was kind enough compliment me and the members of the Investment Committee in pointing out that the Chronicle of Philanthropy ranked the estimated yearly return of 19.6% for the NJPAC’s endowment as #11 of the 72 endowments with similar fiscal year periods.

Correction to last week’s blog

One of the best members of this blog community quite correctly noted that I slipped the decimal to the right when I indicated that a doubling in 100 years was the equivalent of a 0.1% gain per year. Actually on a simple divisor basis it is 1% p.a., and a compound basis 0.70%. We have corrected the original blog on its website, .


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