mini-course series - alternative investments (part 3)

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

ALTERNATIVE

INVESTMENTS

Part III

ALTERNATIVE INVESTMENTS 1

PART III

IBF | MINI-COURSE SERIES

HEDGE FUND CONCERNS

The goal of the advisor is to find hedge funds with a positive and upward bias. Equity

market neutral and global macro have the most conservative risk profiles. The skew

for equity market neutral hedge funds is only slightly negative, while the skew for global

macro hedge funds is positive. Each of these strategies has a low kurtosis. For advi-

sors who want to be careful and cannot justify the added fees of a fund of funds ap-

proach, both styles offer better risk-adjusted returns than the S&P 500. Market neu-

tral managers have a more positive concentrated return pattern, while global macro man-

agers experience a greater return dispersion.

Bias The basis for reviewing individual hedge funds as well as their strategic categories is per-

formance. Biases of hedge fund data have been described earlier. This section expands

upon that discussion.

Survivorship bias means that funds no longer in existence, usually poor performers, are

not part of the database. This exclusion leads to an upward bias in performance report-

ing. This also happens with mutual funds, but it is much more pronounced in the hedge

fund world, partially since the numbers can be so extreme (largely due to the use of lev-

erage) and because the percentage of hedge funds going out of business each year is high

(~ 15%).

A study in Hedge Fund News (August 1999) and the article Offshore Hedge Funds by

Brown, Goetzmann, and Ibbotson, both estimate the average life of a hedge fund manager

is just 2 ½–3 years. Most estimates are that just survivorship bias adds 300–500 basis

points to database returns each year.

A 2006 study by Fung and Hsieh shows how survivorship bias translates into category

returns of 250 basis points higher per year; a study by Ibbotson covering the period

1989–1995 estimates this bias increases return figures by 200–300 basis points a year.

Still yet another study by Ackermann, McEnally, and Ravenscraft (Journal of Finance,

June 1999) finds no consistent bias; the authors believe that while a number of hedge

funds stop reporting because of bad numbers, other funds stop reporting because their

numbers are so good—it is not in their best interest to make such information public

(probably because they are afraid of imitators).

Selection bias means those funds that do well are more likely to report their results to a

database than those still operating but have less than stellar returns. Ackermann, McEnal-

ly, and Ravenscraft believe selection bias adds ~ 140 basis points to reported hedge

fund annual returns.


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Backfilling, sometimes called backfill bias, occurs when a fund’s historical performance

is added to the database. This is a real concern since a hedge fund manager can with-

hold return figures and only contact a database when the fund’s entire track record

looks good. A 2006 study by Ibbotson and Chen estimate backfill bias (instant history)

is 500 basis points a year. A study by Barry believes instant history adds 40 basis points.

Liquidation bias, also known as catastrophe bias, occurs when a fund’s returns are no

longer good; the fund remains operational, but the management has decided to stop re-

porting results to different sources. For example, Long Term Capital Management

stopped reporting returns just a month before it went bankrupt. The management knew

things were beginning to unravel. A month later, the fund’s cumulative losses were ~

100%. Including such a figure would have greatly lowered its category average for the

month.

The catastrophic bias may also be the result of a market or interest rate event—those

hedge funds particularly hard hit would have a strong reason not to report results for

that period and perhaps beyond. Ackermann, McEnally, and Ravenscraft believe liqui-

dation bias adds 70 basis points a year to category returns.

Short volatility bias, which is not included in the summary table on the next page, oc-

curs when a hedge fund increases its short-term returns by collecting option premiums.

The strategy cannot work indefinitely; an unexpected volatility event will eventually

wipe out any of these short-term enhancements.

Hazard bias refers to the proportion of hedge funds that drop out of a database at a given

age. A 2006 study by Fung and Hesich found the highest database dropout rate occurs

when a hedge fund is 14 months old. A large number of funds could be excluded from an

index that required a fund to have at least a two-year record.

Investability bias refers to hedge funds that continue to report their returns but do not

accept new investors. The argument could be made that there are lots of indexes outside

the world of hedge funds that include the same thing (i.e., there are rare coin indexes with

coins that never trade hands and only a handful are in existence). There is also the legiti-

mate opinion that such hedge funds should not be included in the index because they are

likely to contain an upward performance bias.

Fee bias occurs with a large number of hedge funds since individual investors are often

able to negotiate fees. When the fund’s track record is particularly good, the investor’s

ability to negotiate is lessened; when returns are weak, fee negotiation is more likely, par-

ticularly with larger investors.


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Side pocket bias exists whenever a hedge fund manager does not include the valuation

(or returns) of assets it deems difficult to value. Thus, if there is any question about

whether a poor performing hedge fund asset can be “fairly valued,” the hedge fund man-

ager is likely to put it in a “side pocket” and ignore the issue altogether. If the asset later

turns into a winner, it may surprisingly appear back in (and out of the side pocket) with

the fund’s other assets for performance computation. Like other forms of bias, use of a

side pocket allows a hedge fund manager to collect more fees.

As previously discussed, Sharpe ratios have questionable value in the world of hedge

fund comparisons. A 2002 study by Goetzmann, Ingersoll, Spiegel, and Welch shows

how hedge fund managers can increase their Sharpe ratios, at least for some period, with-

out having any skill. The strategy involves selling out-of-the-money calls and puts in an

uneven ratio. This means that regular and ongoing income is created, but it also means

funds are subjecting themselves to extreme events. The strategy shows itself with a return

distribution with a shortened right tail and a fat left tail. The use of leverage can also

help.

The table below summarizes information from six different studies: [#1] Park, Brown,

and Goetzmann (Hedge Fund News, August 1999); [#2] Brown, Goetzmann, and Ibbot-

son (Journal of Business, 1999); [#3] Fung and Hsieh (Journal of Financial and Quanti-

tative Analysis, 2000); [#4] Ackermann and McEnally (Journal of Finance, June 1999);

[#5] Barry (MFAC Research Paper, September 1992); and [#6] a 2006 study by Ibbotson

and Chen.

Hedge Fund Database Returns: Impact of Biases

Study

#1 #2 #3 #4 #5 #6

Survivorship Bias 2.6 3.0 3.0 0.0 3.7 5.7

Selection Bias 1.9 * * ** * *

Instant History Bias * * 1.4 ** 0.4 5.1

Liquidation Bias * * * 0.7 * *

Total 4.5% 3.0% 4.4% 0.7% 4.1% 10.8%

* Not estimated / ** No impact


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If these results are even fairly accurate, return figures for hedge fund database categories

is incredibility misleading. For example, Study #1 comes up with a total of 450 basis

points (4.5%) that should be subtracted from a hedge fund performance database for any

given year—and this study did not include the added impact of backfill (instant history

bias) or liquidation bias. Similarly, a number of other totals from the other five studies

are also missing biases that could greatly increase their total return estimates.

Even without factoring in all the biases described in previous paragraphs, the total for

each study ranges from 70–1080 basis points per year. Based on this analysis alone, it

does not seem hedge fund reporting services have much validity. Moreover, these bi-

ases cannot be diversified away by a “fund of indexes” since all indexes suffer from these

biases.

Hedge Fund Performance According to Ibbotson, from 1995 through 2009, hedge funds had actual (adjusted for

backfill and survivorship bias) compound returns of ~ 7.6% versus 8% for the S&P, 10%

for small cap stocks, 8% for long-term government bonds, and 6% for medium-term gov-

ernment bonds. Industry data shows annualized pre-fee returns of 15% for hedge funds.

FEES

By regulation, mutual funds and ETFs cannot accept an incentive fee; only a management

fee can be used. Over 70% of investible hedge funds charge a 1–2% annual management

fee; 80% of “live” funds also charge a 20% performance fee. Management fees for

hedge funds range from 1–3% a year and incentive fees can be as high as 40%.

Based on management incentives, a study by Kaxemi and Li shows a hedge fund is likely

to increase its volatility (risk) if: [1] management is not poised to receive an incentive fee

based on y-t-d returns, [2] fund NAV has been below its high-water mark for a significant

period, and [3] fund assets are marketable enough to change strategies or leverage in or-

der to try and enhance returns. The authors also believe small and newer funds are likely

not to adjust their risk in order to earn more in incentives.

Incentive (performance) fees are usually subtracted at year-end. Indexes provide

monthly data that does not factor in or pro rate incentive fees. Thus, at the end of

November for any given year, the funds in an index have accrued 11/12 of any incentive

fee due; a number not subtracted from the index (or database). There is also the issue of

fee consistency.


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Almost all hedge funds are structured as a private limited partnership. Negotiated fees

are not known by other investors in the same fund. This means the rate of return

will vary among investors. This also means an index’s return may overstate what a new

investor could expect, particularly if some of the hedge funds in the index have an ap-

pealing track record (since they would then be less likely to reduce their fees to new in-

vestors).

AVOIDING THE HIGH-WATER MARK

Hedge funds often include a “high-water” mark, meaning management does not collect

its incentive fee until the fund surpasses its previous high. It has been argued that manag-

ers who are below this mark during the fourth quarter may become overly aggressive in

the hope returns will be high enough by year-end to warrant a bonus. However, there is a

way around this, without being reckless.

A far easier solution is to close the fund and open a new one. When this happens, any

former high-water mark disappears. This is exactly what John Meriwether did with JWM

Partners; he closed JWM and put all the proceeds into JM Partners when the fund was

down 44%.

REDEMPTIONS

Each hedge fund has its own redemption policy. Most often, the policy states the request

must be made at least a quarter in advance—if money is needed by year-end, the request

had better be made before September 1st. A timely request does not necessarily mean the

investor will receive back cash.

A redemption request may mean the investor receives 90% of what is due, while the

hedge fund holds back 10% until year-end accounting is finished—which is likely going

to be April of the following year (even though the redemption was April of this year).

Whatever percentage is received may not result in a check. Instead, the fund may be

structured so that payment is in kind—such as illiquid securities from a bankrupt compa-

ny.

If the hedge fund is doing well, getting money out with the proper request should not be a

problem. However, if the fund is in the middle of a large transaction and believes a liqui-

dation could harm other shareholders, management may be able to “gate” the money

(lock it up until a later, more convenient, time). If money is gated, which usually only

happens during bad times, the investor will get it back in 1–3 years.


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There is a common complaint among hedge fund investors that their money is not very

accessible. While this can be true, there is also the reverse reality. A few hedge funds are

so successful they want to return investor money as soon as possible. The fund’s manager

may no longer want investor money since returns must be shared—once “gold” is hit,

ditch investors and take all future profits (even though the risk of finding the successful

investment was borne by the investors).

PORTFOLIO CONSTRUCTION

A major theme in the study of any alternative investment is whether or not it should

be added to a client’s portfolio, and if so, how much. Most public pension funds have

< 5% of their assets in hedge funds. A number of studies show the best risk-adjusted re-

turn portfolio would have a 100% weighting in hedge funds. Obviously, this is something

few, if any, of an advisor’s clients would go along with. At the other end of the spectrum,

investors who can tolerate high risk are likely to have 0–2% of their holdings in hedge

funds.

It is important to keep in mind asset allocation models that include hedge funds as poten-

tial parts of a portfolio suffer from the same hedge fund database and index biases de-

scribed earlier; overall, this means hedge fund returns are likely to be overstated by

at least 300–500 basis points a year. An overstatement of just 50 basis points could

greatly increase the recommended weighting of a hedge fund in an asset allocation pro-

gram (software). The next table compares three traditional indexes to a large number of

different CISDM hedge fund indexes for the period 1990–2008 (source: CISDM).


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Traditional Indexes vs. Hedge Fund Indexes [1990–2008]

Return Std. Dev. Skew Max. Loss Corr.*

Bonds (Barclays) 7% 6% 0.2 -10% 0.1

S&P 500 8% 16% -0.7 -45% 0.6

EAFE 5% 18% -0.6 -49% 0.5

CISDM Hedge Fund Index:

Fund of Funds 8% 5% -1.3 -18% 1.0

Equal Weight 13% 8% -0.7 -21% 0.9

Merger Arbitrage 10% 5% -1.1 -6% 0.7

Global Macro 11% 7% 1.1 -8% 0.6

Event-Driven 11% 7% -1.6 -20% 0.8

Equity Mkt. Neutral 9% 2% -0.5 -3% 0.6

Equity Long-Short 12% 9% -0.3 -17% 0.8

Distressed Securities 12% 8% -1.4 -21% 0.7

Convertible Arbitrage 8% 5% -5.1 -22% 0.7

CTA Asset Weighted 11% 11% 0.6 -11% 0.1

CTA Diversified 10% 12% 0.4 -17% 0.1

CTA Discretionary 12% 8% 0.8 -6% 0.4

* Correlation to the CISDM Fund of Funds Index

THINGS TO DO

Your Practice

For clients who want to make a gift to a newborn grandchild, consider having them

buy one share of Disney stock. This is one of the few stock certificates that is very

colorful and includes a number of Disney characters—a perfect gift to frame next to a

crib.

The Next Installment

Your final installment, Part IV, will cover private equity. You will receive Part IV in

a week.


PART III


Learn

Are you ready to take your practice to the next level? Contact the Institute of Busi-

ness & Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist®

(CAS®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate

degree. For more information, phone (800) 848-2029 or e-mail [email protected].

mailto:[email protected]

mini-course series - alternative investments (part 3)

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