Friday, 9 November 2018

Pro-forma vs realised hedge fund portfolio returns

Most hedge funds promise high uncorrelated returns but many dont deliver, or performance erodes over time. What impact does this have on investor returns?

When buying new managers/ maintaining existing ones you need to think about the probability of the realised return scenarios. Versus recent history, what's the probability the fund makes;
  • more
  • the same
  • less
  • blows up
Small confidence interval funds
If you buy an investment grade bond fund with say 3 years duration, then likelihood of achieving the running yield over say 3 years is very, very high, lets say 90% probability. Interest rates could rise or fall, but you also have bonds maturing and can reinvest proceeds.

In a high yield bond fund its still fairly high despite the risk of a default/ spread blow out cycle. In a normal spread widening cycle high yield bonds might see 500bps of widening, so 10-20% price drop, but you will have a much higher running yield after that and if the manager avoids defaults then you get to reinvest coupons at the higher yield. So on a longer term basis you could be confident of generating a return that is similar to the running yield but with uncertainty over the path and the potential for a 1-2 year drawdown at some point.

Hedge fund returns have a large confidence interval
Hedge funds however are unbenchmarked strategies. With the exception of stressed credit there is no anchor or 'pull to par' for returns. Equity bear markets can last years and recoveries can be even longer.

As such the confidence interval for the return for an individual hedge fund has to be large.
Anecdotally the HSBC hedge weekly report by year end often has an 80% plus spread between the top few hedge funds and bottom few. Its not uncommon for certain managers to frequent both lists in different years.

Question: What percentage of hedge funds meet their double digit return goals?

My experience with low beta/ uncorrelated institutional portfolios is that realised returns, by the time you have redeemed underperforming hedge funds, are about half of the pro-forma returns.
I.e. if you want to realise 7-8% you need to buy funds making 15% at the point in time that you buy them. This raises an issue if you buy low returning funds.

Question: What if I buy 'conservative' funds that lose less when they go wrong? Generally speaking the average return is lower in my experience and you can see that in the HFRI indices.

Let's assume we buy a portfolio of 9 funds that has an expected/ recent return of 7%, what is the expected outcome of that portfolio:

3 funds make 7%
3 funds make 2%
3 funds average 0%

What is the weighted return of that portfolio? Its 3%, or less than half of the expected 7%, before costs.

What evidence can I supply for portfolio realised returns being roughly half pro-forma expected returns? Simple look at the HFRI FOF index returns and the UCITS index returns.

The UCITS market is dominated by absolute return funds targetting 7%. What is the return for the UCITS index in an environment of QE and ZIRP that has supported asset classes?
The UCITS index has made approximately 10% or an annualised 1.1% since 2010. Meanwhile 'successful' UCITS funds make 7% annualised.

What if there is a bear market?

3 funds make 3%
3 funds make 0%
3 funds average -3%

Weighted return drop to zero. In a market crisis like 2008 the returns could be worse.
So what if we buy double digit returning funds?

3 funds make 12.5%
3 funds make 7%
3 funds average 3%

The average is 7.5%, even though all the funds bought had been making 10-20% prior to being bought. For this to work you need to avoid bad blow ups though.

To boost these returns:
  • If you can average a higher hit ratio than 1/3 that it would boost returns significantly
  • If you have one outlier high returning fund, say 25% IRR, then it would boost the portfolio return to 9%
  • If you aggressively redeem low returning funds, that would boost portfolio returns
  • If you want to take beta bets then thats a slightly separate issue but you can use that to push up the IRRs

What if there is a bear market?

3 funds make 10%
3 funds make 4%
3 funds average -3%

Portfolio still makes almost 4%. It really helps if you have some funds that can make double digit returns in a bear market like 2008, or if there are funds that can exploit opportunities like the 'Big Short' in sub-prime.

Conclusion
So there you have it: buying low returning funds and running them for years.

Its the answer as to why UCITS investors and consultant led institutional investors have hardly made any money from hedge funds.

Why do they keep doing it? Or are they now rotating the money into 'return free risk' in conventional private lending strategies, thereby setting up a great secondaries opportunity when defaults rise.

As for institutional interest in hedge funds I just wonder how it works if QT pushes many asset classes into synchronised grinding valuation bear markets.

The best thing for the hedge fund industry's returns would be for these institutions to exit enmasse and reduce the level of me-too competition in markets.

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