Hedge Funds: Should You Bother?

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Daniella Quinn
5 years ago
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2 Today s Discussion Hedge funds as a group Have hedge funds demonstrated alpha in aggregate? Might the future be different? Should you bother? The individual hedge fund Independent peer groups vs. self classification Morningstar s classification system New Morningstar hedge fund ratings

3 Today s Discussion YTD Returns S&P 500 TR (Official) 100 MSCI EAFE USD 100 Morningstar 1000 HF PR USD 100 DJ AIG Commodity TR USD 100 BarCap Global Aggregate TR USD 100

4 Today s Discussion Year Returns S&P 500 TR (Official) 100 MSCI EAFE USD 100 Morningstar 1000 HF PR USD 100 DJ AIG Commodity TR USD 100 BarCap Global Aggregate TR USD

5 Today s Discussion Name 5 Yr Annlzd Top 3 Categories Morningstar EM Equity HF PR USD 8.35 Morningstar Europe Equity HF PR USD 7.10 Morningstar Distressed Secs HF PR USD 6.45 Bottom 3 Categories Morningstar Convtbl Arbitrage HF PR USD Morningstar Dvlp Asia Equity HF PR USD 0.79 Morningstar Multistrategy HF PR USD 2.41

6 Today s Discussion Name Total Return YTD Top 3 Categories Morningstar Short Equity HF PR USD Morningstar Global Trend HF PR USD 4.98 Morningstar Global Non Trend HF PR USD Bottom 3 Categories Morningstar EM Equity HF PR USD Morningstar Global Equity HF PR USD Morningstar US Small Cap Eqty HF PR USD

7 Hedge Funds Over the Past 5 Years Hardly Overwhelming

8 The Picture Looks Different When Sliced This Way The bad news: The excess returns are shared roughly equally between investors and managers (alphas are approximately equal to fees)

9 The Picture Isn t Quite That Good Part 1 Traditional Beta (used for the study on the previous page) Conventional risk exposures (large-cap U.S. stocks, European fixed income) Alternative Beta Nonconventional risk exposures that can be replicated and measured (commodities, volatility straddles) Exotic Beta Nonconventional risk exposures that cannot be replicated and measured (banking, footballers transfer values) So manager contribution has been less than the alphas shown in the previous page Some of the betas not captured through traditional studies Some hedge fund alpha is therefore measurement error

10 The Picture Part 2 Measured Risk Is Understated Fat tails! Inherent in strategies with optionality (Lo experiment) Exacerbated by leverage, illiquidity Recent developments illustrate the dangers of liquidity traps Fat tails captured by standard deviation calculations Sticky pricing Illiquid securities (private placements, obscure assets) Lack of regulation + incentive to smooth returns Morningstar finding: 20% of hedge funds have serial monthly correlations of greater than.3 The upshot Hedge funds look safer than they actually are Again, some hedge fund alpha is measurement error

11 Still, Hedge Funds Do Appear to be Doing Some Hedging

12 The Risk Reduction for Emerging Markets is Significant

13 But Our Opening Graph Was No Mirage: Alpha Appears To Be Shrinking Estimates of average monthly hedge fund alphas (before expenses)* Category Equity Hedge 0.8% 0.5% 0.2% Event Driven 0.5% 0.5% 0.2% Merger Arbitrage 0.4% 0.3% 0.1% Convertible Arbitrage 0.4% 0.4% 0.0% Source: Lars Jaeger, Partners Group

14 At the Same Time, Traditional Betas are Rising Returns from true alternatives appear to have been squeezed by large asset flows Global equity markets generally rising The easiest way to make double-digit gain buy stocks Typical hedge-fund position from 2003 mid 2007 Long value, small companies, emerging markets Short growth, large companies That trade began to fail last summer Hedge funds are now in a transition period

15 No Free Lunch Volatility & Returns are Related

16 So is Fund Size: The Small-Fund Effect

17 Betas, Alphas, Fees Source of Returns Traditional Assets Beta Return Alpha Return Fee Long-term After-fee Total Return = alpha + beta fees Stocks High Low Low High Bonds High Low Low Medium Cash Low Low Low Low Alternatives Hedge Funds Medium (Rising) High (Shrinking) High High? Medium?

18 Summarizing the Current State of the Industry The good Alternative and exotic betas provide diversification low correlations with conventional markets Most hedge fund categories still offer protection against stockmarket declines (they hedge!) The bad Shrinking alphas, more beta Significant event risk due to lack of liquidity, leverage At 2.3 trillion dollars, are hedge funds too large to exploit the next market trend?

19 Moving to Individual Funds The Problem With Self Categorization Take four clearly defined hedge fund categories Equity Net Long Equity Net Short Equity Variable Equity Market Neutral Run simple one factor beta test on funds that have been categorized according to their own descriptions Equity Net Long statistically significant beta of >.20 Equity Net Short statistically significant beta of < -.20 Equity Variable betas not as above Equity Market Neutral betas not as above, muted volatility Results 48% of funds miscategorized

20 Morningstar Hedge Fund Categories November 07 The goal move from self-classification to independent classification Initial cluster analysis to better identify strategy groupings Quantitative techniques R Squared Volatility Qualitative techniques Strategy literature Portfolio holding characteristics via survey Telephone conversations with managements The result: 17 categories for direct funds (funds of funds to be classified in 2008)

21 The New Categories Direct Funds

22 Morningstar Hedge Fund Star Ratings November 07 How successful has this fund been, given its strategy? In contrast with existing hedge fund ratings systems, Morningstar s ratings: Address performance, not operations or creditworthiness Are conducted for all direct funds in Morningstar s database Are done free of charge to the hedge funds themselves Serve as a starting point, not as a conclusion Ratings based on a minimum of 38 months of performance data

23 The Star Rating Further Details Risk adjustment based on expected utility theory Does not assume normality of market returns Sensitive to all variations skewness, kurtosis, etc. Risk adjustment factor (gamma) can be adjusted to suit differing tolerances of risk Resistant to manipulation Returns exhibiting autocorrelation are unsmoothed One recent academic comment Morningstar s risk-adjusted measure is the only measure that is tamper proof

$The Rating Pull in all eligible hedge funds in a Morningstar Category Assign fractional weights to each share class in a multi-share$

24 The Rating Pull in all eligible hedge funds in a Morningstar Category Assign fractional weights to each share class in a multi-share fund Rank all funds in category on Morningstar Risk Adjusted Rating in descending order Assign stars based on bell curve distribution.

25 Are Morningstar Ratings Persistent? (Preliminary Evidence) Test the persistency of our rating methodology over different periods of time. Applied the ratings to the set of eligible funds as of December 2004 Adjusted for survivorship bias Reapplied the ratings to the same set of funds as of December 2007 and examined the differences Did one star funds as of Dec 2004 continue to be poor risk-adjusted performers versus peers? Did five star funds as of Dec 2004 continue to be superior risk-adjusted performers versus peers?

26 Certainly, There Was Much Change! Dec 2004 Dec ,114

27 But Some Stability Among the Extreme Cases 5 Stars and 1 Star

Morningstar Reports Hedge Fund Performance for April 2009; Asset Flows Through March

Media Contact: Alexa Auerbach 312-696-6481, alexa.auerbach@morningstar.com FOR IMMEDIATE RELEASE Morningstar Reports Hedge Fund Performance for April 2009; Asset Flows Through March CHICAGO, May 20, 2009