The Importance of Track Record in Hedge Fund Investing

Let’s do a little experiment. Lets take 1000 fair coins. Let’s give them names and flip them to see which ones come up heads and which ones come up tails. Now let’s take another 1000 fair coins and do the same, given them unique names and flip them recording which ones come up heads and which ones tails. While we are flipping this second batch, flip also the first batch and record their results. Now add another 1000 coins naming them, flipping them and recording their results. Do this for the previous batches as well. Continue doing this until you have 8 batches of 1000 coins.

Using simple rules of probability, of all the coins that have been flipped 8 times, that is from the first batch of course, how many would one expect to have come up heads precisely 8 times? Being fair coins, the number would be 0.5 raised to the 8th power X 1000, or roughly 4 coins. Of all the coins that have been flipped precisely 7 times, that is from the second batch, one would expect the number of coins to have only ever come up heads in every toss to be 0.5 raised to the 7th power X 1000, or roughly 15.

8 heads out of 8 tosses: 4 coins in 1000
7 heads out of 7 tosses: 8 coins in 1000
6 heads out of 6 tosses: 15 coins in 1000
5 heads out of 5 tosses: 30 coins in 1000

Thus, out of 8000 coins there are 57 coins who have never come up tails. Now supposing we loosely defined heads as the ability to generate good returns in a given year and tails the complement, and if we gave the coins strange names like ABC Capital, DEF Capital, GHI Partners, JKL Asset Management and so on…

Here in our database of 8000 coins there are 57 who have never had an unsuccessful year. Because we stopped our count at 5, you could compare this to searching a hedge fund database for funds with at least years of track record and have been successful in every year of their operating history.

The thing about the coins though is that the probability that one chosen from that 57, would have no more than an even chance of coming up heads next flip.

The above example is just an illustration. The definition of successful in a given year has not been clearly made. What is a successful year for a hedge fund? It depends on the level of risk they take. It depends on conditions in the markets. Depending on how demanding you are, success could be a very tough condition and the probability of being successful could be significantly less than 50%.

Let’s do some calibration. Let us say that 5% of all managers have a good 3 year track record. We are thus defining success. This implies that success occurs with 37% probability. Using this probability we go through our calculation again and find that there are

0 managers with 8 years of unblemished track record.
1 with 7 years
2 with 6 years
7 with 5 years
18 with 4 years

Thus 28 with at least 4 years of unblemished track record. That’s still quite a lot. And on the information we have, any one of these 28, thus chosen would have a 37% chance of being successful in the next year.

Performance of Hedge Funds in 2006. How did the Big Name Hedge Funds do?

2004 and 2005 were terrible years for hedge funds. If the HFRI Index is anything to go by, the average hedge fund returned 9.05% in 2004 and 9.27% in 2005. Performance in years 2001 and 2002 were worse but those years saw equity markets in free fall. 2003 was a recovery year in equities and 2004 and 2005 while wobbly, were good years on the whole where markets both equity and fixed income found their feet. 2006, however, was a pretty good year. The HFRI Index rose 12.85% for the year.

Despite the good performance on average, in 2006, many investors continue to be disappointed with hedge funds. There are several reasons for this. One is of course the high profile demise of Amaranth, a 10 billion USD hedge fund that quickly became a 3 billion USD hedge fund by way of losses in leveraged bets on natural gas (and hence indirectly, the weather!) The robust performance of equity markets and to a lesser extent bond markets around the world. A third and less obvious reason is that many of the big names, with whom the bulk of the money in hedge funds is invested with, did poorly. Among the large multi strategy macro managers, Moore Global and Moore Fixed Income returned 9.53% and 2.57% respectively for year to November 2006. Tudor managed 10.70% in the same period. Blue Crest Capital returned a mere 6.40% and Bridgewater Pure Alpha only 3.19%. Even when returns were higher and into the low to mid teens, performance lagged previous track record. 11.75% is poor for Perry Partners, as is 11.32% for Brevan Howard.

So who did well? Quite a few. Tewksbury continued to prove that a systematic mathematical approach can work consistently. 27.93% for year to November 2006. CQS in the mid teens was consistent with previous track record and steady as she goes. GLG Market Neutral was another good performer. Where Lansdowne stuck to stocks they performed well. Some of the big winners of 2006 were behaving out of character and should have triggered alarm bells instead of blissful acceptance.

All the above performance numbers are year to November 2006.

All in all, the winners of 2006 were not the usual suspects. They were the smaller, younger managers. Conversations with managers, prime brokers and industry specialists seem to indicate a certain sense of disarray among the big macro and multi strategy fund managers. Perhaps the world has become a more complex place, perhaps we are at another one of those inflexion points we only recognize three years hence. For now, the safer strategy would be to be specific, to be technical and to focus on managers operating in particular areas. For example, dedicated stock pickers be it in Asia, Europe or the US, or sector specific equity managers but where macro factors don’t complicate matters. Event driven and distressed securities managers for example are sufficiently specialized away from the vagaries of macro policy and geo politics.

Some argue that the big names have had their day and are never coming back. Some say that the last year was a temporary lull and that the experience and resources of the big name hedge fund will return them to glory. It’s a difficult call and certainly not one I can make.

Some evidence that hedge fund managers don’t always know what investors want

I was doing the usual rounds in Connecticut visiting hedge fund managers a couple of months ago and I was talking to a convertible arbitrage manager who was seeking to grow his business. The said fund had had a long track record of success in the field of convertible arbitrage chalking up an average performance of nearly 12% p.a. over the last 15 years. In 2004 the convertible market was shaken and investors left in droves. What was a billion dollar business shrank to nearly half. The manager quickly reacted by changing his business by adding a multi strategy credit fund to his product range. The fund did reasonable well and he managed to raise significant capital.

When I spoke to him, he was lamenting that his business had hit a plateau and that assets were not growing. He was pushing his multi strategy fund but unfortunately was not reaching out to new investors. He felt that he had already reached out to all the investors that were interested in his product. This was to an extent true. In the entire hour that we chatted, he only mentioned his old convertible fund but once and only as an afterthought. Performance of the fund had perked up. Convertibles had suffered a very specific problem to do with the dynamics of trading and ownership, a problem which started in 2004 and dragged out till 2005. Since then general conditions had improved significantly, the problem had gone away.

It never occured to the manager that the way to grow his business was to start marketing that old convert fund of his. More astute investors were already moving back into converts and would have loved to invest with a manager of his track record and experience. He was so focused on managing money that he just didn’t see the demand.

Further evidence that hedge fund managers don’t always know what investors want

Just yesterday I was talking to a fund manager from Australia. He had launched an equity and equity options fund two years ago, performance had been good and he was on the road to raise capital.

His pitch was to launch immediately into the options trading strategy, which was fairly sophisticated and interesting. He spent nearly an hour talking about his choice of strikes, his decision to take delivery or roll, how he rolled, how he scaled in or out of a trade. At the end of this I asked him a simple question: How do you choose which stocks to execute your options strategy on?

It was only then that he began to tell his story of stockpicking and he turned out to be a good stockpicker. What to him was a matter of course, to an investor was of utmost importance. Here was a stockpicker, someone who analysed companies, their asset value, their cash flows and earnings, their return on investment, the quality of management, the soundness of their business model, and what does he concentrate on? Trade expression. The pitch was back to front. Selling his story as he had done so to many investors would have led them to lose interest or misunderstand and run scared. The diligent investor would have discovered his edge or his fundamental style of investing, but they would have been made to work hard to find it.

This manager was trying to raise capital. Clearly he wanted to impress. But he didn’t know what investors want and so went about it in reverse. He could have said, look, I’m a good stock picker, I am an investor, not a trader. Here is how I pick stocks. When I am done picking stocks, I find the best way of expressing my long and short ideas. Here is my option strategy. Instead he would have given a potential investor the impression that here was an options trader, mostly writing options and thus open to tail risk, often getting exercised and thus not the best risk manager, and with little consideration to the quality of the underlying securities…

A word about Style Drift and what it means to be a hedge fund

Style drift is when a trader is flexible about their trading strategy and it doesn’t work. Nimble is when a trader is flexible about their trading strategy and it works. It isn’t style drift if it remains within the experience and expertise of the trader. It’s style drift if its out of their comfort zone.

One of the important ways that hedge funds differ from traditional investment strategies is their flexibility.

The concept of the hedge fund bears consideration. Hedge funds are not perfectly hedged, nor do they always hedge, even imperfectly. A more useful characterisation of the hedge fund strategy is that it is an optimal solution in a constrained optimisation where the constraints are a bit more complicated than one finds in traditional long only unlevered investment strategies.

The traditional view is that a hedge fund strategy involves augmenting the traditional long only strategy with short selling and leverage and use of hybrid and derivative instruments. From an economic efficiency perspective, the converse view is that the hedge fund strategy is a less, albeit more complex constrained way of investing. The traditional strategy is therefore a very tightly, and simply constrained (no shorting, no leverage, no derivatives, little cash) investment strategy.

Hedge fund strategies are more flexible and useful since the objective function can be specified to reflect absolute returns (alpha), benchmarked returns (portable alpha), risk adjusted returns (high information ratio), or any number of metrics that best reflect an investors goals over various time horizons.

The feasible set is similarly flexible and can handle the constraints imposed by an investor for reasons of risk management, liquidity or regulatory compliance. By reason of its flexible constraints hedge fund strategies can also be constructed to higher or lower risk tolerances to suit investor appetites. This flexibility allows the investor to define a suitably spacious set within which to express their skill. Too restrictive, and although the risks become more clearly defined, the less room there is to manoevre and the more difficult it is to generate returns. In fact, the more one becomes dependent on certain factors, although such dependence may not be immediately apparent. Too relaxed and the risks become less well defined and the opportunity for style drift and accidents increases.