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Hedge fund returns
Past hedge returns: more than meets the eye

Depressed stock markets have given rise to the mainstream popularity of hedge funds. Slick marketing for such funds often includes a snapshot of how these funds have performed over the past several years, compared to well known stock indexes, like the S&P 500 and the S&P/TSX Composite (formerly TSE 300). However, there is more than meets the eye of past hedge fund returns. Depending on the source, hedge fund returns may be biased.

Clifford Asness, Managing Principal of AQR Capital Management LLC in New York, recently wrote a sober reminder of the biases present in hedge fund databases. In an article entitled, "Do Hedge Funds Add Value?" (AIMR Conference Proceedings on Hedge Fund Management, 2002) he warns of the following:

Infrequent pricing

Since many positions held by hedge fund managers are illiquid (i.e. tough to sell quickly without driving down the price), actual market values for many securities are unavailable. Recall that this same issue came up in our discussion of the valuation risk with labour sponsored investment funds . However, unlike the laws governing LSIFs, which that mandate internal values be approved by an independent valuator, hedge fund managers have more flexibility on valuing illiquid positions.

A common way to value such holdings is to simply use an amount equal to the lesser of original cost or fair value. But the fuzziness comes into play in the determination of "fair value"? In other words, it's very subjective - and that's a potential risk. Consider the simple example of a stock that is purchased today at $10. Over the next few weeks, the market falls ten percent but no trades take place in that stock. But since the managers assess its value to be more than $10, they carry it at $10 (the lesser amount) on the fund's books. It's likely the stock's price would have fallen somewhat just by virtue of the market's decline. Keeping it at $10 on the books may be unfair.

(Recall that a stock's quoted price often fluctuates more than its "true value". Today's market environment is a perfect example of how good stocks can see their prices get undeservedly beaten up. However, the true volatility of quoted market prices still should be reflected, even if the "true value" doesn't change.)

An unrealistically high share price will keep the fund's unit price unduly high - thereby favouring sellers and punishing buyers.

A by-product of such uncertain valuation policies is an artificial smoothing of fund volatility (up and down price swings). This smoothing effect de-emphasizes a fund's downward price swings, making its risk/reward combination look better than in reality.

The more illiquid a manager's holdings, the more potentially biased its performance.

Survivorship bias

When a hedge fund winds up or ceases to exist, some hedge fund databases will completely eliminate that fund's current and historical data. This is a common criticism of historical mutual fund performance. When mutual fund category averages are quoted, most omit the funds that have "died" over the years. The assumption underlying this bias is that funds that cease to exist have, as a group, poor historical performance. So, taking this group of poor performers out of a category average artificially boosts the category's track record.

Backfill bias

Funds with some history that are not currently included in any hedge fund database may, at some point, ask to be included. Since these funds wouldn't be new (just new to the database) these funds may be allowed to provide all of their historical data from inception, even though they were not part of the database in previous years. Managers requesting this are likely to have good performance, thereby creating another upward bias to historical hedge returns. Think about it - a manager is not likely to want to be included in a database (and compared against the competition) unless fund performance looks favourable.

Selection bias

Some managers simply choose not to be included in hedge fund databases. There are two potential reasons for a lack of inclusion. Managers with poor performance won't want to look bad against better performing peers. Also, some hedge managers may simply be at a point in their careers where they have their ideal level of assets under management, and simply don't want any more business. Hence, this factor may be positive or negative depending on the circumstances.

Some hedge fund databases claim to be free of some or all of these biases. However, when faced with an impressive track record of a hedge manager (or a fund category), an awareness of potential biases will help in your decision-making process.

Next week: We'll look at historical hedge fund returns with these biases in mind and provide some tips on portfolio inclusion.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...