Most people would agree that herding cats is hard. A majority, if pressed, would tend to the view that it is also pointless. Some would say the same of hedge fund managers.
It is almost certainly challenging, exasperating even, to try to organise the skittish homo hedgefundus individualis into homogenous groups. However, there are some very good reasons for thinking carefully about what style means in the hedge fund world. Style analysis is a key step in the analytical process for most institutional investors in their long-only portfolios, providing much-needed context to the evaluation of investment manager performance. It is also an important first step in the portfolio construction phase, allowing investors to identify and then manage the key contours of alpha in each segment of their portfolios. It should be no surprise then that institutional investors and their advisers are grappling with the question of how to apply style analysis techniques to hedge fund investing.
Styles and benchmarks have a long and, arguably, illustrious history in long-only investing. Over the past three decades they have brought greater order to an otherwise chaotic investment arena. They have promoted understanding and confident decision-making on the part of institutional investors. Against this must be levied the unproven and unmeasured cost of reducing the flexibility available to fund managers. (The fact that many hedge fund managers decry benchmarks and constraints does not invalidate them; in the absence of a suitable experimental control there is no way of knowing whether the current crop of hedge funds strategies would still be effective if institutional investors behaved differently). Love them or loathe them, styles and benchmarks are an important part of the institutional investment landscape.
There are perhaps three reasons why market-driven benchmarks and styles are less prevalent in the hedge fund arena. Each is understandable. All are dissolving in the face of pressure from institutional investors.
The first, but least defensible today, is resistance from hedge fund managers themselves. Many hedge fund managers cite the constraints placed on long-only funds managers as a key reason for their ‘defection’ to the hedge fund world. Increasingly, though, hedge fund managers are realising that the desire to understand and measure on the part of investors and their advisers is not an attempt to hamstring their efforts. Rather it arises from a legitimate need on the part of institutional investors, given their roles as representatives and delegates, to demonstrate true diligence (ie, not just legalistic ‘due diligence’, but full attention and consideration) to all aspects of their investment portfolios.
The second is the poor quality of most hedge fund data. Survivorship bias, performance fees, stale prices, data gaps – the litany of shortcomings is well-known. However, after a slow start, this is being addressed apace. Building on the work of some earlier authors, Russell researchers Ross and Oberhofer recently outlined procedures for addressing two recurrent issues in hedge fund performance analysis, the existence of performance fees and the impact of stale prices on apparent volatility. Using some new techniques, they derive some encouraging results: skill exists but it is not ubiquitous. In fact, hedge fund universe means appear to have a negative alpha (but a high beta). Importantly, though, individual manager analysis exhibits many cases of positive alpha and low betas, even when correcting for stale pricing.
This finding is more intuitively acceptable than if the research had discovered an investment master race, all the members of which regularly turn in spectacular returns, which is what the hedge fund rhetoric sometimes implies. It also underlines another important point; to build a successful hedge fund strategy, investors need to be able to identify and appoint the best managers – there is no free lunch. More broadly, though, such studies, and continuing efforts to clean up historical performance records, are contributing materially to investor confidence in the hedge fund industry.
The third reason is the nature of the investment strategies pursued by hedge funds. Early hedge funds of the type lionised by the press, such as the Soros funds, pursued an often eclectic and wide-ranging assortment of strategies. Some persist in this approach, though the ranks of this type of fund are vigorously winnowed by volatile markets and fickle investors. The idiosyncracy of these types of hedge funds undermines any attempt at systematic research, never mind the application of benchmarks or style-descriptors. Not surprisingly, most institutional investors found such hedge funds hard to incorporate into their decision-making process.
This last reason, too, is less relevant today. Today the main appeal of hedge funds for institutional investors is the way hedge funds can unlock pockets of inefficiency and value in the investment markets. The opportunities may arise because of the way the investment habitats of different participants in the markets overlap, as for instance in mergers arbitrage, or don’t overlap, as in the case of convertible bond arbitrage. Either way, the underlying source of the return streams demonstrated by hedge funds managers is not created magically out of the ether. The returns earned by hedge funds managers are rooted in the structure and operation of investment markets.
Sound familiar? It should. This characterisation mirrors long-only equity styles to an uncanny extent. It is the foundation of the market-linked benchmarks, the so-called ‘style-indices’, that are found at the core of style analysis on the long-only world. It took a great deal of work by many researchers to arrive at the formulations of equity style that are take for granted today, but it seems reasonable to assume that a similar formulation might to be possible in the hedge fund world.
One thing that has obscured this for many people is the publication of peer-related ‘hedge fund style indices’. Valuable as these calculations are, they are misnamed. Rather than indices of the style, they are means (or sometimes medians) of the universe of peers in that style classification.
That is not to say that the style classifications inherent in the indices are not useful. Quite the contrary, the mapping of hedge fund strategies to components or facets of underlying markets such as convertible bond arbitrage, merger arbitrage, fixed income arbitrage, market neutral, long-short, event-driven is an important precursor to more sophisticated forms of style analysis. It would be premature to try to link these classifications specifically to risk exposures in the way that is common in the long-only world, but there is no doubt that the availability of alpha in many, if not all, of these areas expands and contracts through time. That alone is an important insight for the process of portfolio construction in this area.
However, there still remains the task of specifying an appropriate benchmark for each given strategy type, or style. This is not a trivial exercise, and so in some cases there is perhaps still no satisfactory answer. In some cases the relevant benchmark is short-dated fixed income, perhaps proxied by the Euribor or US T-bills rate, but in many cases this is inappropriate.
Many hedge fund strategies carry residual market risks, or have some other compensated risk factor present in their return streams, and these need to be built into the performance of the benchmark. After all, if hedge funds are supposed to be a source of exceptional alpha (returns from skillful forecasting), it is important to distinguish accurately those elements of the return stream that are betas (returns for risk) lest they be misdiagnosed as arising due to skill. A can of worms, indeed. More work is clearly required in this area to ensure that any style analysis conducted rests on a solid foundation.
If you want to use style analysis as a guide in portfolio construction, it is not enough to classify funds and specify benchmarks. Funds also need to be profiled according to the main drivers of differential return. Investors need to understand how, by mixing and blending managers, they can influence the expected return patterns and the types of risks they accept.
This is by far the most intellectually challenging part of the process, and not surprisingly, the least developed. However, in recent research, Leola Ross of Frank Russell’s Capital Markets Research Department has made some initial steps, distilling common hedge fund manager styles into a series of fundamental economic and market phenomena. The research, a form of scenario analysis, finds that hedge fund managers within a style classification perform differently but explicably under different scenarios. It also went a long way towards explaining why the performances of the collection of hedge funds managers in any given universe appear to diverge so much, given the ostensible similarities in ‘style’. Looking at a small sample of convertible arbitrage managers the research identified that managers had different sensitivities (and success rates) to the factors affecting the returns from convertible bond strategies, such as movements in option adjusted spreads and yield curve slope. Similar results were generated for market-neutral, long/short, fixed income arbitrage and event-driven hedge fund managers.
Just as differences in exposure to earnings surprise, price/cashflow and dividend yield (for example) are helpful for portfolio managers building multi-manager portfolios in equity markets, so these new indicators of style point to an emergent, more robust framework for style analysis in hedge funds. In the case of hedge funds, though, style sensitivities need to accommodate leverage (which inflates the style beta) and asymmetric payoffs (which places kinks in the beta). Again, challenges remain, but the way forward is becoming clearer.
The hedge fund world is a diverse place with few boundaries. As institutional investors have started to look seriously at hedge fund investment, they have brought with them some of the tools and techniques they have found to be effective in more traditional long-only investment strategies, including benchmarks and notions of investment style.
This is not necessarily a bad thing for hedge funds managers. On the one hand it will increase investors’ confidence, which should speed up otherwise tentative decision processes. More importantly, if designed and interpreted thoughtfully, appropriate benchmarks and style analysis should also provide insight for investors in a way that is not invasive and so does not distort what the hedge funds managers are attempting to do.
That, at least, is the theory and the initial signs are encouraging.
Scott Donald is director, product development and marketing, and Derek Doupe is director, alternative investments, at Frank Russell Company