Sources of Hedge Fund Returns: Alphas, Betas, Costs & Biases. Outline

Size: px

Start display at page:

Download "Sources of Hedge Fund Returns: Alphas, Betas, Costs & Biases. Outline"

Mark Andrews
5 years ago
Views:

1 Sources of Hedge Fund Returns: s, Betas, Costs & Biases Peng Chen, Ph.D., CFA President and CIO Alternative Investment Conference December, 2006 Arizona Outline Measuring Hedge Fund Returns Is the data biased? Is bigger better? The Sources of Returns s, Betas & Costs Adjusting for lagged betas Asset Allocation Stocks, Bonds & Hedge Fund Inputs Optimal Mixes

2 The Growth of Hedge Funds Source: HFR & Van Hedge Advisors Number of funds (in 000s) AUM (in $100B) Median Strategic Allocation to Hedge Funds: US. Tax-Exempt Organizations Goldman Sachs International & Russell Investment Group: Alternative Investing Report % 9.3% 9.0% 8.0% 7.9% % of Total Fund Assets 7.0% 6.0% 5.0% 4.0% 3.0% 2.5% 5.0% 2.0% 1.0% 0.0% (forecast)

3 The Trends in US: Demand ered expected equity & bond returns More allocations to alternative assets & active management (), er returns Diversification Measuring Hedge Fund Returns No requirement to report (Liang, 2003) No requirement to audit Backfill bias Recently studied by Posthuma and van der Sluis (2003) 55% of the history for the average fund in the TASS database with data to 2001 is backfill Ibbotson bias estimate: 3.53% overall Survivorship bias (Brown, Goetzmann, and Ibbotson, 1999; Brooks and Kat, 2001; Liang, 2000) Nonperforming managers cease operations Estimated at 2-3% per year Liquidation bias Posthuma and van der Sluis (2003) estimate to be 50%

4 Measuring Hedge Fund Returns Major indexes are calculated on the fly Not typically biased Usually value weighted Using individual fund data has potential biases Survivorship bias should include active + inactive Back filled data should be excluded Usually equally weighted Updates Goetzmann, Ibbotson, & Brown (1999) which covered Backfill for average TASS Fund Average Primary Category Percentage of History Backfilled Convertible Arbitrage 51% Dedicated Short Bias 64% Emerging Markets 41% Equity Market Neutral 45% Event Driven 57% Fixed Income Arbitrage 48% Fund of Funds 57% Global Macro 57% Long/Short Equity Hedge 50% Managed Futures 72% Other 53% All Funds 55%

5 Some Benchmarks Stocks, Bonds, Bills and Inflation (1995 April 2006) S&P 500 U.S. Small Stock U.S. Int-Term Bonds U.S. 30 Day TBill U.S. Inflation Return* (%) STD (%) * Total compound annualized returns. With Backfill 1. Active Only What is the Return? Hedge fund annualized returns* (1995 April 2006) 2. Active + Inactive Without Backfill 3. Active Only 4. Active + Inactive Return (%) STD (%) HFRI Weighted Composite CSFB/Tremont S&P *Equally weighted compounded annualized return, TASS database.

6 Value Weighted Vs. Equally Weighted* (1995 April 2006) With Backfill 1. Equally Weighted 2. Value Weighted Without Backfill 3. Equally Weighted 4. Value Weighted Return (%) STD (%) *TASS Data (includes only funds that report AUM) active + inactive sample Bigger backfill bias for small funds Value weighted returns are higher Is Bigger Better? (Jan 1995 April 2006) Return (%) Weight (%)* 2004 Min AUM ($M)* Largest 5% Largest 10% , Largest 20% Largest 50% Smallest 50% NA * Most recent data available is through April 2006 Bigger funds may be more skilled on average Possible diseconomy of scale for individual funds

7 CSFB/Tremont Annual Returns % Return Can hedge funds be replicated? Lagged betas Stock, bond & cash betas Is there a positive alpha? The Sources of Returns Sources of returns After fees Systematic beta returns

8 Sources of Returns + Timing Betas Security Selection Systematic Beta Net Return Timing betas are a substantial part of the alpha for most categories, e.g. for L/S equity the bear market beta (0.34) was much lower than the overall beta (0.51) Fees are also a large part of the return Gross Return - Management Fee - Incentive Fee Net Return Returns, s & Betas Equally Weighted* (1995 April 2006) Sum of Betas = 1 Return (%) (%) Stocks Bonds Cash RSQ Equity Mkt Neutral L/S Equity ** Fixed Inc Arb Global Macro ** Index ** The good news: s are highly statistically significant Betas on stocks and bonds are mostly low Most are good diversifiers (low RSQs) *Active + inactive, no backfill ** Significant at 5% confidence level

9 Sources of Returns Equally Weighted* (1995 April 2006) Pre-Fee Return* Fees* Post-Fee Return* Systematic Betas R Equity Mkt Neutral 11.3% 3.5% 7.9% 1.9% 5.9% L/S Equity Fixed Inc Arb Global Macro Index 12.7% 3.7% 9.0% 3.0% 5.9% The bad news: Some of the net (after fee) returns are from systematic betas The excess returns are shared roughly equally between investors and managers (alphas are approximately equal to fees) *Fees are based upon median fees, usually 1.5% and 20%. All results are active + inactive, no backfill. Evaluating Performance with Ratios April 2006 Return Sharpe Ratio Info Ratio Fee Ratio Equity Mkt Neutral 7.9% 1.9% L/S Equity Fixed Inc Arb Global Macro Index Sharpe ratios for stocks were also 0.67 over the period s, information ratios, and alpha fee ratios were negative for mutual funds over the period

10 Summary: Source of Hedge Fund Returns Measuring Returns Adding dead funds and excluding backfill substantially reduces equally weighted returns Asset weighted returns are higher and less subject to bias s and Betas Even after correcting for biases, almost all alphas are significantly positive Still, over 66% of the net (after fee) return was from systematic betas Asset Allocation s approximately match fees (3.0%) Hedge funds can provide diversification Sources of Portfolio Return Source of Returns Traditional Assets Beta Return Return Fees Long-term After-fee Total Return = alpha + beta fees Stocks Bonds Medium Cash Alternative Hedge Funds?

11 Sources of Portfolio Return Source of Returns Traditional Assets Beta Return Return Fees Long-term After-fee Total Return = alpha + beta fees Stocks Bonds Medium Cash Alternative Hedge Funds Depends on Manager Skill Thank you

The ABCs of Hedge Funds: Alphas, Betas, & Costs

The ABCs of Hedge Funds: Alphas, Betas, & Costs Working Paper : Alphas, Betas, & Costs Roger G. Ibbotson, Ph.D. Professor in the Practice of Finance Yale School of Management Chairman & CIO Zebra Capital Management, LLC. Phone: (203) 432-6021 Fax: (203)