Lies, damned lies and hedge fund performance statistics

The shine appears to have gone hedge fund performance in recent years, at least compared to the glory years of the 1990s. Indeed hedge funds have posted negative returns in two of the past four years (2008 and 2011).

Nonetheless according to a new report produced by The Centre for Hedge Fund Research at Imperial College London commissioned by KPMG and the Alternative Investment Management Association (AIMA) hedge funds still outperformed equities, bonds and commodities over the 17 years from 1994 to 2011.  

The report, entitled “The Value of the Hedge Fund Industry to Investors, Markets and the Broader Economy”, found that hedge funds generated annual returns of 9.07 percent net of fees over the period, compared to 7.18 percent for global stocks, 6.25 percent for global bonds and 7.27 percent for global commodities. Moreover, hedge funds achieved these returns with considerably lower risk volatility as measured by Value-at-Risk (VaR) than either stocks or commodities. Indeed, hedge funds’ volatility and VaR came in at level similar to bonds. The research also demonstrated that hedge funds were significant generators of “alpha”, creating an average of 4.19 percent per year from 1994 to 2011.

“This research is powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities and to do so with lower volatility and risk than equities,” said Andrew Baker, AIMA’s chief executive. “The most interesting point to come out of this research is that it disproves common public misconceptions that hedge funds are expensive and don’t deliver. The strong performance statistics, showcased in our study, speak for themselves,” added Rob Mirsky, KPMG’s UK head of hedge funds.

Or does it? Mr Baker’s claim may be somewhat disingenuous because on this writer’s reading of the report The Centre for Hedge Fund Research are not comparing like with like. Hedge funds typically employ leverage, which can magnify returns. The market indices used to measure the performance of global bonds, equities and commodities do not.

Leverage levels have probably fallen considerably in the wake of 2008’s global financial crisis. But according to Credit Suisse, for example, global hedge funds were still 2.52 times leveraged at the end of 2010. And this would almost certainly have had a significant impact on returns. It could easily more than explain account for the return differential, especially relative to global commodities and equities.

   

This is certainly the case for private equity, another “alternative” investment. At first sight returns from a typical private equity appear to outperform equity indices, such as the FTSE All Share Index. Lever the index to the same level of private equity fund and the situation is reversed.  

A lawyer’s paradise

“The United States has fiver percent of the world’s population, 25 percent of its incarcerated people and 50 percent of the world’s lawyers. The legal profession takes about 10 percent of the country’s GDP, approximately $1.5 trillion, a sum close to entire GDP, depending on exchange rates, of Russia, India or China.”


Conrad Black, The Spectator, 21 April 2012.   

Career Risk: The ultimate investment fundamental

Yorkshiremen have a reputation for plain speaking. So it should come as no surprise that it takes a Yorkshireman, in the form of Jeremy Grantham, the co-founder and chief investment strategist of Boston, Massachusetts-based Grantham, Mayo Van Otterloo (GMO), a big investment management firm, to get down to the realities of investing. Forget about putting client interests first. For virtually all investment professionals the real fundamental that drives behaviour is keeping their job.

“The central truth of the investment business is that investment behaviour is driven by career risk,” he writes in the lastest GMO Quarterly Commentary. “In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes  knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially.”

The problem, is, however, that this creates “herding”, or momentum. And this results in prices deviating from “fair value” by a considerable margin.

“There are many other inefficiencies in market pricing, but this is by far the largest,” he continues. “It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market.  

“This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1 percent of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19 percent two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!”  

Market prices tend to revert back to their mean, however, a phenomenon that underpins Mr Grantham’s - and GMO’s investment management philosophy. Unfortunately, as he is the first to admit, this is not always a comfortable position to take. Market prices can take a very long time to revert back to the mean even if they appear very expensive or very cheap.  

“Ridiculous as our market volatility might seem to an intelligent Martian, it is our reality and everyone loves to trot out the “quote” attributed to Keynes (but never documented): “The market can stay irrational longer than the investor can stay solvent.” For us agents, he might better have said “The market can stay irrational longer than the client can stay patient.””

But how long can a typical client remain patient before demanding action or taking his business elsewhere?

“Over the years, our estimate of “standard client patience time,” to coin a phrase, has been 3.0 years in normal conditions,” says Mr Grantham. “Patience can be up to a year shorter than that in extreme cases where relationships and the timing of their start-ups have proven to be unfortunate.

“For example, 2.5 years of bad performance after 5 good ones is usually tolerable, but 2.5 bad years from start-up, even though your previous 5 good years are well known but helped someone else, is absolutely not the same thing! With good luck on starting time, good personal relationships, and decent relative performance, a client’s patience can be a year longer than 3.0 years, or even 2 years longer in exceptional cases. I like to say that good client management is about earning your firm an incremental year of patience. The extra year is very important with any investment product, but in asset allocation, where mistakes are obvious, it is absolutely huge and usually enough.”

As Keynes pointed out in The General Theory of Employment, Money and Interest funds overseen by investment committees and boards tend to be the most critical of fundamental value, driven investors.

“What Keynes definitely did say in the famous chapter 12 of his General Theory is that “the long-term investor, he who most promotes the public interest … will in practice come in for the most criticism whenever investment funds are managed by committees or boards,” “ continues Mr Grantham. “He, the long-term investor, will be perceived as “eccentric, unconventional and rash in the eyes of average opinion … and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.”

Mr Grantham and GMO have certainly experienced considerable criticism from investors, not least for calling the collapse of the technology bubble of the late 1990s two to three years early, (although GMO’s performance during the deep bear market of 2000 to 2003 more than made up for the opportunities apparently foregone)..

“Reviewing our experiences of being early in several extreme outlying events makes Keynes’s actual quote look painfully accurate in that “mercy” sometimes was as limited as it was at a bad day at the Coliseum, with a sea of thumbs down,” he concludes. “But his attribution, in contrast, has proven too severe: we appear to have survived.”

Proactive risk management in the personal pensions market: Buy a pub and a gun

Saving for a pension often seems to be a mugs game given minimal investment returns and falling annuity rates (although pension providers probably still continue to do quite nicely).

Of course there are alternatives, although the often favoured strategy of using the family home as an alternative to a personal pension fund seems a little misguided. Notwithstanding all the periodic hyperbole residential property is not a particularly good investment. At best it probably keeps in step with the cost of living - but little more. Moreover, unlike pension fund investors house-owners no longer get any tax relief.

Investors could try something more exotic. You could always buy a pub. One local resident disillusioned with the current UK private pensions regime decided to go down this particular route. He also bought a gun to protect his investment.

“I lost faith in pensions so I bought a pub for the value of the property and business carried on in it,” he says. However we all know that ownership is only guaranteed by laws, and if laws break down, you can be dispossessed by anyone with enough force. So that’s why I bought a gun.”