Hedge funds should rue the day that the term “absolute returns” was coined

Despite begin caught with their hands in the beta cookie jar last quarter, hedge funds had one of the best relative performances ever in Q3 – beating equity indices by a country mile.  Most industry participants acknowledge that various “alternative betas” and even, as we have recently seen, traditional betas have found their way into hedge fund returns.  And some now attribute hedge funds’ returns since 2003 as simply repackaging beta and selling it at alpha prices.  While countless reports of abysmal hedge fund performance have included the caveat that they have still beaten the S&P 500 handily this year, the industry remains in the cross hairs of the mainstream media for what it alleges was “promising absolute returns in good times and bad”.

Despite the marketing power of the “absolute return” moniker, its adoption by the hedge fund industry is now coming back to haunt it.  Although we know very few hedge funds naive enough to make such promises, the tacit endorsement of the term by the industry at large has obscured the benefits of old-fashioned relative performance.

Institutional investors have largely adopted hedge funds not because of their performance, but because of their diversification properties – as indicated by their low market correlation.

A survey conducted last year by French business school Edhec shows that virtually all performance measures used by European institutional investors are essentially relative, not absolute.

The simplest measure cited by respondents was the average outperformance vs. the benchmark.  The  Information Ratio goes a step further by measuring the benchmark outperformance relative to the standard deviation of that out performance.  But just in case a fund simply levers-up the benchmark index in an “up” year (thus producing a high information ratio), Jensen’s alpha accounts for the correlation between the fund and the index (the lower the correlation, the higher the alpha ceteris paribus).

While varying in their sophistication, all three of these measures are essentially relative.  And all three are used by institutional investors to measure the performance of hedge funds as well as traditional long-only strategies.

Edhec’s survey also explores the methods used by institutions to calculate alpha.  Writes Edhec:

“One of the most commonly cited performance measures in investment management is of course alpha. Judging from the financial press, the quest for alpha is still very much predominant in the industry. Obviously one cannot talk about alpha if one does not know how to measure it.”

As the chart below from their report shows, a popular back-of-the-envelope metric is performance vs. peer group.  While not technically alpha, normalizing for the investment strategy does remove the ability of a manager to win accolades simply because she was in the right place at the right time.

More accurate techniques for calculating alpha (from multi-factor models, market models and returns-based style analysis) implicitly measure fund performance relative to a benchmark (the market or some other model).

Of course, the market benchmark is a blunt instrument that could easily suggest a manager produces alpha when they simply pursued a strategy that did well.  So institutional investors use customized benchmarks that more accurately reflect the manager’s strategy.  Still, Edhec found that a large portion of investors still measured their managers relative to broad market indices.

Since they are free to shift their strategies, hedge funds tend to have time-varying correations to markets, making relative performance very difficult to calculate (i.e. relative performance to what?).  But the fact remains, hedge funds – like all other investments – are measured by institutions on a relative basis, not an absolute basis.  While early investors into the asset class (family offices, private banks) may have been more enamoured with the promise of “absolute” returns, many of the new investors have a more methodical (and realistic) view of hedge funds.  This may not stem the short term outflows from the industry, but the institutional investors we’ve talked to have been more disappointed with what they see as a high market correlation (low alpha) than the recent drawdowns.

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  1. Harry M. Kat
    October 20, 2008 at 5:29 pm

    It is interesting to see how eager people still are to continue the hedge fund myth. Over the last couple of days alone, I have heard several people say: “my hedge funds came down 10%, but that is still a lot better than the 30% I lost on my stocks”, suggesting that hedge funds did deliver on their promise. Unfortunately, this is another nonsense argument. An average stock portfolio has 15% volatility, while an average hedge fund portfolio has a volatility of 5%. Under those assumptions, the probability of an equity portfolio losing 30% is more or less equal to the probability of a hedge fund portfolio losing 10%. In other words, taking into account the difference in risk profiles, hedge fund performance has been as extreme as that of the stock market. Now who would ever have predicted that?

  2. Peter Urbani
    October 20, 2008 at 7:01 pm

    Whilst I agree that the term ‘absolute returns’ has been misinterpreted as applying to all hedge funds as a FoF manager it pains me to admit that Prof. Kat’s comments in this regard are accurate. I would hope that, to the extent that there is some level of ‘hedging’ or embedded optionality in HF distributions, this is not a one to one comparison due to the distribution of returns being hopefully truncated in the case of HF as opposed to Equities where the assumption of normality is less egregious. To some extent this is the same as Taleb’s recent comments about extreme risks and representative of the ‘hedges’ not being held far enough out of the money or in the tail to provide sufficient protection against such extreme market moves. The failure to adequately hold sufficient protection against the possible impact of such excess Kurtosis is as much due to a failure of imagination (How bad can it get ?) as to the commercial realities of the cost of holding such protection in a competitive environment where not everyone does so.

  3. Oana
    October 21, 2008 at 6:34 pm

    Eliminating the beta in one’s HF is/was an expensive proposition. We’ve been doing an overlay of puts on part of our HF portfolio. Nobody expected such a huge decline so whatver we hedge didnt help much in % terms more like a bandaid. Its a sad thing that us as investors had to hedge the hedgers. Except if a manger chose to allocate disproportionally this year (at the cost of cutting returns if this year had turned out to be “normal”) to short biased funds nothing was spared.

    I can tell you from what I know from various managers – plain vanilla out of the money puts on indexes to hedge PART of the market exposure used to run at a minimum about 1-1.5% and above cost from assets to be hedged all about this year up until august. It wasnt quite cheap.

    Fat tail risk hedging (how fat is your “fat” and what is the worst assumption?) using knock down options (in retrospect would have been a brilliant idea if only anyone implemented it).

    That was the cost in June this year (we split the amounts of exposure/correlations to various markets at that point in time):

    ” -5-10 MM notional for each underlying
    -Maturity – 4 month

    “Down & In” Puts – the options only become effective if the index trades below the barrier during the life of the trade:
    a. 95% strike price, 61.75% barrier, up front premium paid = 3%
    b. 90% strike price, 64.0% barrier, up front premium paid = 3%

    a. 95% strike price, 72.75% barrier, up front premium paid = 3%

    “Up & Out” Puts – the options no longer exist if the index trades through the barrier during the life of the trade
    a. 95% strike price, 103.2% barrier, up front premium paid = 3%
    b. 90% strike price, 104.3% barrier, up front premium paid = 3%

    a. 95% strike price, 103.1% barrier, up front premium paid = 3%

    Vanilla put options struck at 90% or 95% range from about 3 – 7% assuming a 4 month maturity. Introducing the barrier takes down the cost by 30 – 50% depending on the underlying / structure.”

    Yes the cost of holding protection to for such extreme environments is a numbers killer.

    Bottom line seems to be – you want extreme protection you have to give back in returns, maybe ending up with bond like returns with unknown vol instead of stocklike returns with supposedly less vol.
    All in all i think if an investor didnt come in with the preconceived idea that HF should be 100% absolute returns one could be somewhat at peace with the recent performance overall.

    Also it seems to me that ballpark common sense measures actually worked better as predictor than sophisticated theories, in essence what i’ve seen is:
    – you see a 2 digit stdev in a HF and cant take a 2 digit decline a month dont invest there. Period.
    – you see stock like returns or a bit better with higher stdev or equal to the index (for L/S equity or EM/foreign oriented funds)
    – you see a fund going down close to or 2 digit in a month be prepared for the worst to happen

    I have had some results with an omega ratio calculator which for some reason this year in Aug. seemed to point that some funds were struggling and raised some red flags. For what is worth it also had some “fakes” in other years when we had drops in omega and nothing important happened. Overall funds with constant prior to Aug. or improving omega did best compared to peers during this “episode”.

    I can also say that even funds that were in cash at 30-40% in March (i was complaining at that time that we dont pay them to hold cash) were still caught in Sept-Oct avalanche and dropped anywhere between 5-8% despite the cash, despite the defensive stance.
    Nothing helped except being net short or 100% cash.

    On the bright side whoever will survive this will likely stand to make a lot of money, plus less competition if we indeed see a rather large # of funds closing will also be beneficial.

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