The hedge fund fraud is in the residuals
May 10, 2012
Good Quafafew event in NYC this week, with Michael Markov of MPI on "Hedge Fund Replication: Methods, Challenges and Benefits for Investors". To cut a relatively long but enjoyable presentation short, Michael presented some interesting empirical evidence about hedge fund performance.
Firstly, he showed how many (most) hedge fund styles were able to deliver performance that had better risk/return profile than many mainstream investment portfolios, obviously including the ubiquitous 60% in equity 40% in bonds strategy. Given this relative outperformance in terms of risk and return for many hedge fund styles, Michael put forward the idea that asset managers seeking to invest in hedge funds should take more interest in indices of hedge funds than is currently the case.
For a particular hedge fund style, to obtain a performance level that was better than 50% of the managers was actually quite good, particularly when he showed that the risk level was approximately better than 75% of the hedge funds within each class. Also, when you look at the performance over longer time periods (rolling 3 years say) an index outperformed many more of the funds in a particular investment style (sounds like a bit of the advantages of geometric vs. arithmetic averaging at work somewhere in this to me).
As an aside, he said that most hedge fund replication products do not mention tracking error and often instead talk about near perfect correlation with the hedge fund index being replicated. He was at pain to point out that it was possible to construct portfolios with near perfect correlation that have massive tracking errors, and so investors in these products should be aware of this marketing tactic (or failing, depending on your viewpoint).
Michael should some good examples of how his system had replicated the performance of a particular hedge fund style index, and how this broadly uncovered what kinds of investments were broadly being made by the hedge fund industry during each time period under consideration. He is already doing some work with some regulators on this, but most interestingly he showed how he took a few hedge funds that were later found to be involved in fraudulent activity, and worked backwards to find out what his system thought were the investments being made.
He then showed how by taking away the performance of the replicated fund away from the actual hedge fund results posted, the residual performance for these fraudulent funds was very large, and he implored investors in "stellar" perfoming hedge funds to do this analysis and really quiz the hedge fund manager for where this massive residual performance actually comes from before deciding to invest. In summary a good talk by an interesting speaker, which surprisingly for a New York Quafafew event was not interupted too many times by questions from the hosts.