Despite begin caught with their hands in the beta cookie jar last quarter, hedge funds had one of the best relative performances ever in Q3 - beating equity indices by a country mile. Most industry participants acknowledge that various “alternative betas” and even, as we have recently seen, traditional betas have found their way into hedge fund returns. And some now attribute hedge funds’ returns since 2003 as simply repackaging beta and selling it at alpha prices. While countless reports of abysmal hedge fund performance have included the caveat that they have still beaten the S&P 500 handily this year, the industry remains in the cross hairs of the mainstream media for what it alleges was “promising absolute returns in good times and bad”.
Despite the marketing power of the “absolute return” moniker, its adoption by the hedge fund industry is now coming back to haunt it. Although we know very few hedge funds naive enough to make such promises, the tacit endorsement of the term by the industry at large has obscured the benefits of old-fashioned relative performance.
Institutional investors have largely adopted hedge funds not because of their performance, but because of their diversification properties - as indicated by their low market correlation.
A survey conducted last year by French business school Edhec shows that virtually all performance measures used by European institutional investors are essentially relative, not absolute.
The simplest measure cited by respondents was the average outperformance vs. the benchmark. The Information Ratio goes a step further by measuring the benchmark outperformance relative to the standard deviation of that out performance. But just in case a fund simply levers-up the benchmark index in an “up” year (thus producing a high information ratio), Jensen’s alpha accounts for the correlation between the fund and the index (the lower the correlation, the higher the alpha ceteris paribus).
While varying in their sophistication, all three of these measures are essentially relative. And all three are used by institutional investors to measure the performance of hedge funds as well as traditional long-only strategies.
Edhec’s survey also explores the methods used by institutions to calculate alpha. Writes Edhec:
“One of the most commonly cited performance measures in investment management is of course alpha. Judging from the financial press, the quest for alpha is still very much predominant in the industry. Obviously one cannot talk about alpha if one does not know how to measure it.”
As the chart below from their report shows, a popular back-of-the-envelope metric is performance vs. peer group. While not technically alpha, normalizing for the investment strategy does remove the ability of a manager to win accolades simply because she was in the right place at the right time.
More accurate techniques for calculating alpha (from multi-factor models, market models and returns-based style analysis) implicitly measure fund performance relative to a benchmark (the market or some other model).
Of course, the market benchmark is a blunt instrument that could easily suggest a manager produces alpha when they simply pursued a strategy that did well. So institutional investors use customized benchmarks that more accurately reflect the manager’s strategy. Still, Edhec found that a large portion of investors still measured their managers relative to broad market indices.
Since they are free to shift their strategies, hedge funds tend to have time-varying correations to markets, making relative performance very difficult to calculate (i.e. relative performance to what?). But the fact remains, hedge funds - like all other investments - are measured by institutions on a relative basis, not an absolute basis. While early investors into the asset class (family offices, private banks) may have been more enamoured with the promise of “absolute” returns, many of the new investors have a more methodical (and realistic) view of hedge funds. This may not stem the short term outflows from the industry, but the institutional investors we’ve talked to have been more disappointed with what they see as a high market correlation (low alpha) than the recent drawdowns.
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