INSIGHTS
                     
Assessing The Drivers of Hedge Fund Performance

May 2018 by Joe Burns

ASSESSING THE DRIVERS OF HEDGE FUND PERFORMANCE - CoverAssessing broad hedge fund performance is challenging, with thousands of funds spread across multiple strategies and an inter-quartile spread between the top and bottom-performing funds far wider in alternative assets (e.g. private equity, private debt and hedge funds) than in traditional bond and equity markets.

DOWNLOAD PDF



Assessing broad hedge fund performance is challenging, with thousands of funds spread across multiple strategies and an inter-quartile spread between the top and bottom-performing funds far wider in alternative assets (e.g. private equity, private debt and hedge funds) than in traditional bond and equity markets.

Investors know that despite recent underperformance, most hedged strategies outperformed global equity markets substantially in 2000-2002 and again in 2008, with certain funds delivering positive performance in one or both periods as equities declined by (40%-50%). Perhaps more interesting, during the five years preceding the Great Financial Crisis (2003-07) hedge funds performed roughly in-line with equities, with half the volatility1.

Looking forward, it is increasingly important to understand the drivers of returns that underpin hedge fund strategies, as opposed to evaluating past performance in the context of a rapidly changing market environment.

As evidenced during the mid-2000's, hedge funds have historically generated strong performance in an upward trending market, while truncating downside risk when markets retreat. More important than market direction in developing an expectation of future returns is the market environment, specifically volatility, correlation and dispersion. Most hedge fund strategies are not “short the market” per se; instead, they are effectively short correlation and long dispersion, meaning that a market with exceptionally high correlation and low dispersion is the worst environment for most hedged strategies.

Fortunately for hedge fund investors, the tide has been turning. We have now seen a nearly 2-year period of rising interest rates, first in the U.S. and more recently across the globe, which has coincided with a decline in cross-asset correlations and an uptick in hedge fund performance.

Effectively all hedge fund strategies require some level of price dispersion, benefitting from lower correlations within and across asset classes globally. While the 2009-2015 environment was dominated by Central Bank policies and various forms of quantitative easing, we have seen a paradigm shift towards new return drivers more recently. Unsurprisingly, the performance of many hedged strategies has picked up considerably over this period. Against the backdrop of “expensive” stocks and bonds, this differentiated performance serves an increasingly significant role within a diversified portfolio.

In addition to assessing market conditions, investors should command the right level of transparency in better understanding the primary sources of return in each underlying investment. These return drivers and risk factors can be analyzed qualitatively, statistically and operationally.

From a qualitative perspective, investors should understand the specific holdings (long and short, where applicable) along with the construction of the overall portfolio including position sizing; the regional, sectoral and stylistic composition of the fund; and the liquidity, concentration, leverage and complexity of the overall investment strategy.

Statistically, beyond a simple assessment of historical returns, investors should feel comfortable with the risk-adjusted performance profile relating to their pre-investment and forward-looking expectations. This includes an analysis of realized volatility, downside risk and drawdown potential, market beta (dependency on broader markets in driving future returns), correlation with other holdings within their portfolio, and the contribution to returns from alpha, or manager-specific performance above and beyond a relevant benchmark.

Investors should also assess the operational capabilities of each rm, regarding their internal policies and procedures, pricing and valuation methodologies, connection with top-tier service providers and commitment to institutional best practices in managing not only an investment fund, but an overall business. Too often investors rely upon realized performance and extrapolate future returns when making an investment decision. Drilling into the sources of return, the statistical robustness of the performance and the strength of each rm’s operational business processes is as important, and likely more predictive in assessing the future impact of each investment within a diversified portfolio.

Equity valuations today are comparable to the late 1990s, after which hedge funds outperformed equities by roughly 800bps per year with half the volatility2. While predicting future market returns is extremely difficult, investors must have a certain expectation for each investment within a diversified portfolio. For hedge fund investors, transparency across strategies coupled with continual evaluation of changing market conditions can provide substantial bene t in helping clients achieve their long-term objectives.

END NOTES

(1) The S&P 500 Index generated a 12.8% annualized return (with reinvested dividends) with an 8.6% standard deviation from Jan.’03throughDec.’07, as compared to a 12.1% return and a 4.5% volatility for the HFRI Fund Weighted Composite Index over the same period. Source: Evestment

(2) The S&P 500 Index generated a negative (0.6%) annualized return (with reinvested dividends) with an 18.9% standard deviation from Jan. ’98 through Dec. ’02, as compared to a 7.8% return and 9.1% volatility for the HFRI Fund Weighted Composite Index over the same period. Source: Evestment


IMPORTANT INFORMATION / DISCLAIMER

These materials are for informational purposes only and are not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an o er to sell, a solicitation of an o er to purchase or a recommendation of any interest in any fund or security described herein. Any such o er or solicitation shall be made only pursuant to the fund’s confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein.

Past performance is not indicative of future results. Products offered by iCapital are typically private placements that are sold only to qualified clients of iCapital through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described involve long lock-ups and do not provide investors with liquidity.

If you are not the intended recipient of this material, please destroy this material. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This information is the property of iCapital Network. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. (d/b/a iCapital Network). These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. iCapital and iCapital Network are registered trademarks of Institutional Capital Network, Inc. Additional information is available upon request.