By Bill Kelly, CEO, CAIA Association
What can the NCAA basketball tournament tell you about your investment portfolio? As it turns out, quite a bit. For those of you who simply don’t care about the annual bracket ritual, it is quite easy to get you up to speed. The bottom line is that past performance is no guarantee of future results for most things in life. This has always been the stated regulatory case in investing and maybe basketball too. Let’s take the Loyola-Chicago Ramblers to prove this point. The fact that they have made it this far into the tournament has befuddled all but the less than one half of one percent of the more than tens of millions of ESPN bracket players who picked them to advance this deep into the annual contest. Assuming there is some information advantage here, and this group is the closest proxy to expertise, it’s no wonder that the experts sometimes look and feel very foolish.
Much has been written about hedge fund performance in 2017 and, more recently, for the first two months of 2018. Turns out that 2017 was a pretty good year for this space: absolute return composites went 12 for 12 in the win column, a streak that was last seen almost 15 years ago. It was also a good year for investment performance clocking in at about 12% (although the S&P-obsessed Financial Times might take issue) and industry assets under management reached a new all-time high of $3.6 trillion. The party continued in January where the underlying indices extended the win streak to 13 in a row and posted some of the best monthly numbers not seen since 2010. If only the longed-for higher rates and greater volatility would come back, God only knows how great this could really be!
Well we found out two days into February, when the 10-Year Treasury started flirting with 3% and volatility, once a lamb, proved to be a very angry lion. Fast forward to the end of the month and the league tables resemble the many busted brackets of the basketball enthusiasts. Needless to say, the win streak ended, and YTD performance went negative pretty much across the board. Managed futures got hit particularly hard, posting one of their worst months of all time depending upon whose category index you follow.
What’s wrong with this picture? Perhaps you are looking at the picture in the wrong way. There is a bit of a tendency to think about the outlook for hedge fund performance in 2018, as the risk-on equity markets continue to get even longer in the tooth. This is a flawed premise in such a basic way. Hedge funds, like mutual funds are industries, not asset classes. When is the last time you read about the annual outlook for mutual funds, ETFs or UCITS? When you have tens of thousands of strategies in one conveniently distinctive wrapper, drawing conclusions on the latter to reach investment decisions on the former is exceedingly short sighted. The same is true for hedge funds with an even more important subtext. There are approximately 10,000 hedge funds around the world and no two are alike. There are, broadly speaking, certain categories such as global macro, market neutral and the aforementioned managed futures, but collectively and categorically each strategy is unique, and the performance returns from top to bottom quartile are many times separated by thousands of basis points. If you want to use the published indices as the starting point for due diligence, know that you are only touching the tip of a very large iceberg. Look no further than what happened to managed futures. Trend-following simply means following the trends, and many of these funds quite happily followed the longer-term equity trends right over the sizeable February speed bump which is reflected in the numbers. Is this the time to lock in losses or take a pass based on a one-month composite index? If so, the investor may resemble the many NCAA bracket players who are now on the sidelines wondering how so many seemingly inferior teams have risen to dominance amid So Much March Madness.
Seek diversification, education and know your risk tolerance. Investing is for the long term.