Look at return patterns and how returns are generated.

It is estimated that there are now close to 7,000¹  hedge funds managing close to $1 trillion. We estimate that the number of firms is growing almost 30% annually in the United States and the assets they manage are growing more than 40% annually. Similar to concerns about the myriad of mutual fund choices, investors face a similar dilemma about how to choose a successful hedge fund. Unlike mutual funds, which are regulated and must meet stringent reporting and valuation criteria, most hedge funds are not registered, causing confusion about performance, fees, holdings and risk-taking. Thus, selecting a hedge fund can be a daunting task, but not an impossible one for the educated investor.²

As in the selection of any investment, the investor should understand the nature of the investment including expectations of returns and risk. In this article we will focus on various important aspects of hedge fund performance. We will point out the danger in relying on performance as a selection criteria, noting the wide gap in performance among different hedge fund strategies as well as the surprisingly large performance gap within the same strategy during the same time periods. As part of the performance discussion, we will discuss the biases that exist in databases, as well as the impact that fees and expenses can have upon reported returns.

A subsequent article will review the other crucial component of any investment choice-risk. The focus of the article will highlight why traditional and reported measures of risk may not be appropriate when considering a hedge fund investment.

Returns-What Are People Buying?

The term hedge fund is loosely defined and covers a number of different strategies. The performance objective of a hedge fund manager is to produce a targeted return or absolute performance, regardless of the underlying trends in the financial markets. Hedge funds use a variety of tools to implement their strategies, including the use of short selling, derivatives and leverage. Differences in implementation and the varied use of financial instruments lead to a wide difference in performance among hedge funds. Importantly, there are biases in performance databases that can be misinterpreted, leading to incorrect and potentially damaging decisions about which strategy to use or even if investing in hedge funds is appropriate.

Performance Data Biases

Databases may be biased because the data upon which they rely is supplied by the funds themselves. While database providers check the data for reasonableness, the performance is not audited. We make reference to close to 7,000 hedge funds in the marketplace, yet the largest databases consist of only about half that number. While we can speculate why funds choose not to submit their data, we do believe that the databases are a representative universe.

An important result of any fund's discretion to participate in the databases is survivorship bias. If a firm closes its strategy because it is successful or disappears because it has failed, the performance numbers disappear. Also, many new hedge funds do not report their performance data until their success is proven, at which point these firms may "backfill" the data for the past years of performance-causing history to change. There are also those hedge funds that never report results and eventually fail. Those performance numbers were never reported and hence were not captured in any database. Academic studies suggest that survivorship and backfill biases could reduce the reported mean returns 1.4% to 4% annually³.  In recent years it also has been estimated that there may be up to 600 hedge funds annually going out of business. Out of a universe of 7,000 firms, that is a significant portion that may not be reporting results. Hence, survivorship bias and lack of reporting standards are significant issues.

In the last and final caveat emptor, the average statistics, which are calculated from databases, may be additionally biased if these databases calculate averages based on the size of the firm's assets under management. This is another example of survivorship bias, which skews the data by weighting the most successful firms (larger asset size) more heavily. Most practitioners compensate for this bias by using databases that show results equally weighted across all funds so that large funds do not dominate results. While not as serious as capital-weighting the databases, another bias may creep in as managers submit performance data on identical funds. Specifically, there may be two or more funds managed by the same firm in the same strategy with the same or nearly the same returns, thereby skewing results towards that series of funds. Identical, or clone, funds are more likely to be established by more successful fund groups. When looking at overall information in peer comparisons, ask whether or not the peer universe is equal- or asset-weighted, and whether or not cloned funds are prevalent in the data.

Aside from the performance data itself, one should be aware of the impact of fees. During a period of strong performance, fees may not appear to be a significant issue. However, during a period of mediocre performance, fees may tip a strategy into posting a loss. In a traditional investment approach, negative returns do occur from time to time without too much damage to the underlying business of the investment firm. However in a hedge fund, where performance fees are typical, a negative after-fee return may cause severe hardship to the business. Therefore, understanding the fee structure of any fund strategy is important. High-maintenance funds, in particular, may be more vulnerable during periods of subpar performance.

The overall conclusion is that measuring hedge fund performance from databases is skewed towards success and may overstate the average results by a fair amount. The degree of skew is debatable and a subject of intense academic study. In addition, investors should insist on looking at performance that is reported net of fees and expenses in order to get a true picture of the returns that the manager has delivered to clients. 

What Does Published Performances Mean?

Given all of the quality issues highlighted above, why use databases at all? The reason is that they are a good starting point from which to eliminate strategies and/or firms that do not fit other criteria. Databases provide the basis for extensive risk analysis and to establish benchmarks, which can be useful in ongoing stewardship. The performance results used in this article have been "scrubbed" so that all results are net of fees and the averages are equally weighted, eliminating the large-firm bias. The clone strategies and fund of funds data have been removed. Also, each fund's return history has been inspected and obvious errors corrected or the fund has been removed from the data set. In addition, some funds report only on a quarterly basis, but data has been shown as monthly data. The quarterly returns have been eliminated or the funds have been removed. The resulting database we used for analysis contains 1,262 funds available to U.S. tax-paying resident investors. Eliminating the other biases discussed previously takes significant due diligence and manager review-the qualitative assessment that is key to selecting any investment advisor.

To present our results, we started with the database from Hedgefund.net. The database consists of 3,561 funds with assets of $493 billion as of May 2004. After eliminating funds of funds, off-shore funds and clones, we were left with 1,262 U.S. hedge funds.  This group represents 31 different hedge fund strategies, with the bulk of the assets in 12 categories. Hence, our starting point will consist of the top 12 strategies, which comprise 79% of the number of U.S. hedge funds and more than 88% of the assets (Figure 1).

Drilling down within this subset of managers leads to interesting results about the differences in performance among hedge fund strategies.

Figure 2 highlights the mean return and volatility³ of performance for different hedge fund strategies.

    Figure 3 shows the dispersion of returns for the 39 quarters from September 1994 through March 2004 for long/short equity funds. To establish a baseline for comparison, we illustrate the range of results in a universe of long-only, large-cap value managers.  It is apparent that the difference of returns for the same strategy in just one quarter can be very large-more than 180 percentage points for the long/short funds, contrasted with 30 percentage points for large-cap value managers⁵. Additionally, it is noteworthy that the differences are increasing over time, as illustrated in the trend line in the chart.

Figure 4 shows the monthly maximum and average difference of all the major strategies since 1990 or when the data for the strategy started, whichever is later. It can be seen that for the 12 major strategies the maximum differences have been large, and for eight of the 12, on average, the difference has been greater than ten percentage points. And the performance gap is increasing across all strategies as more funds open. Obviously, there is a huge incentive to select the "right" funds and avoid the "wrong" ones.   

    Why not just select the funds that have had the best performance over the last three or four years? Figure 5  is based upon the 269 U.S. hedge funds that have monthly returns from August 1996 through July 2004⁶.  The table shows two periods of subsequent performance for those funds that were the 68 best and 68 worst performers for the 48 months prior to July 31, 2000. In the first period, only 15 of the best performers continued to be top performs for the next year; 40, or 58%, dropped to the bottom half, with 30 of those in the bottom quartile. On the other hand, 23 of the bottom 68 performers were among the best performers one year later. Only 14 remained among the bottom performers. Thus, past performance is not much help in finding future top performers. Even over a longer time period of four years, the results are similar. One difference is that only six funds (8%) stayed among the worst performers.

    After-tax return is another important aspect in evaluating hedge fund returns. While a precise measure is probably not possible, some reasonable estimates can be made. In order to estimate the after-tax returns, a number of factors should be considered: (l) an estimate of what portion of the return will be classified as current income; (2) when the tax must be paid on long-term gains; (3) portfolio turnover; and (4) the use of derivatives.     The latter will have a significant impact on the categorization of returns for tax purposes.

Funds with high turnover may make a Section 475 election, which means they mark the portfolio to market at the end of each year and all gains and losses for the year, whether realized or not, are classified as current income. Funds that use futures contracts are affected by Section 1256 of the tax code. Section 1256 contracts, which include regulated futures and foreign currency contracts, must be marked to market at year end, and associated gains and losses are treated as capital gains and losses, with 60% characterized as long-term capital gains or losses and 40% characterized as short-term capital gains and losses. Finally, some funds make extensive use of trading strategies and redemptions in kind to significantly reduce current taxation on the fund. The investor must insure that a full description of the strategy, turnover, use of derivatives, etc., is provided to the investor's tax advisor so that the advisor can determine the tax impacts of the funds under consideration. This will permit the advisor to help select the funds that are most appropriate for the individual investor's needs and tax situation. While tax leakage is an important consideration in wealth accumulation, selection of a bad fund for good tax reasons will lead to a loss of wealth.

Fees Disclosure

Hedge funds are typically more expensive than traditional mutual funds. Because these are not mutual funds, hedge funds can charge performance fees as opposed to a straight expense ratio. Some of the expenses of a hedge fund are obvious, but some are embedded into the funds. Here is what to look for:

Management fees:  The investment advisor to a hedge fund is usually paid based on an asset-based fee, similar to fees charged by advisors to registered investment vehicles. More than 70% of the managers charge between 1% and 2% of the asset value, with some funds as high as 6%⁷.

Incentive fees: In a hedge fund, incentive fees are based on the fund's net investment income, realized capital gains and unrealized capital appreciation. These fees are paid back to the general partner of the fund and can be well over 20%⁸  of the realized and unrealized gains. While 87% of the funds that we reviewed received a participation rate of 20% of the fund's performance, some were more than 45%.

In a few cases incentive fees are only paid after reaching certain thresholds of performance (benchmarks), so as to protect investors from paying for poor performance. The benchmark acts as a minimum performance bogey before the investment advisor can receive payment beyond the management fee. Most funds have a high-water mark that establishes a baseline each year from which to assess the following year's performance. For example, let's assume an investor in a fund has a net asset value of $1 million and a return of 20% in one year. The next year the fund loses money. Since the fund lost money, there is no performance fee. In fact, the investor will not owe an incentive fee until the fund has had gains such that the net asset value exceeds the high-water mark of $1.2 million.

Also, in some funds the investor pays for certain administrative, legal and accounting fees. Some funds do not charge a management fee, but instead charge all  expenses to the fund. These can be more than 5% of the assets under management. Hedge funds charge a formation expense but, unlike mutual funds, they do not amortize over a period of time.

If returns are reported after all fees and expenses, should an investor care as long as performance is adequate? There is no right or wrong answer, but the question should give an investor pause to understand hedge funds as a business. Regardless of how good a fund's performance is or how bright the fund managers are, if the investment firm goes out of business the investor will not benefit. In many cases, especially small funds, the performance fee can be an important source of paying the rent, paying for critical technology and databases and meeting staff expenses. In the absence of the incentive fee the fund may lose key personnel, resulting in continued poor performance or termination of business. Establishing the right mix of management fees and performance incentives is a delicate exercise. If fees are too high at the same time that performance is poor, the survivorship of the fund may be in question.

Is Performance Audited?

Because hedge funds are private placement securities and are not registered, there is no formal requirement to have the results audited. It is usually left to the investors and the investment advisor to agree on issuing audited financial results. Auditors review compliance with general accounting principles and render an opinion as such. Auditors do not verify the accuracy of how securities are priced. While we suggest that investors push for audited performance results, that will still not guarantee that results are of the highest standards.

Observations And Conclusions

We have discussed the many pitfalls of databases, the dispersion of returns, the impact of fees and the lack of persistence of performance. An investor could wonder if returns have any value at all in the decision-making process. Relative performance may be of little value, but the pattern of returns and how the returns are generated are very important in understanding the appropriateness and desirability of a specific fund. The pattern of returns will be the subject of the next article, which will discuss the many aspects of performance risk that an investor should consider. Due to the complexity of hedge fund strategies, we believe that due diligence should be completed with the help of a qualified investment professional.

What should advisors and investors ask about performance and the pitfalls of relying solely on published peer universes and databases to make investment decisions? We recommend asking hard questions about performance. Most importantly, the investor should have little interest in recent relative returns, but should understand how the returns were generated and the historical pattern of returns. The study of the pattern of returns becomes the study of investment risk.

Risk is more than a simple calculation of standard deviation. The measurement should consider downside risk, distributions of returns and how a specific fund may diversify risk in a portfolio of hedge funds and other investments. Importantly, we strongly suggest analyzing drawdown and to get to know the potential downside of a manager's strategy. In a subsequent article we will shift the discussion toward this important topic. Using the concept of drawdown, we will further explain its implications regarding risk taking and help investors sort out whether or not a particular hedge fund strategy is suitable for their needs.

Eileen Cohen is a portfolio manager  for JP Morgan Fleming Asset Management in New York. William H. Overgard is president of WHO Investment Consulting in Wilton, Conn., (203) 834-2871.