Hedge Fund Conference
Kellogg School of Mgmt
Roundtable Discussion
Hedge Fund Performance Evaluation
Lawrence R. Glosten
Columbia University
The academic approach
• Portfolio manager provides excess return
(over the risk free rate) Xpt in period t
• These returns are modeled as:
Xpt = α + β1X1t + …+ βnXnt + εt
Where the X’s are excess returns that
capture the risks that investors care about
• α is the “value” provided by the portfolio
manager which in general depends upon
the factors that are included
Performance evaluation problems
• There is some suggestion that the excess
returns may be measured with error
• There is some (though certainly not universal)
agreement on what X’s should be used for
modeling simple equity returns
– Fama/French three factors: market, small minus
large, high minus low (book/mkt)
• Less agreement on how to model more
complicated returns from hedge funds
• Worry about performance evaluation affecting
investment strategies
The returns
• Self-reported returns, including back-fill
– Back fill data identified as such
• Some odd statistical properties
– In a market model regression with lags,
lagged market returns have significant
coefficients (Asness, Krail and Liew)
– Hedge fund returns exhibit more serial
correlation than one would expect if returns
were calculated from market prices
(Getmansky, Lo and Makarov)
Modifications to standard
performance evaluation
• Non-linear terms—options on the market
(Glosten, Jagannathan)
– Merger Arb writing puts (Mitchell, Pulvino)
– Trend following buying straddles (Fung and Hsieh)
• Lagged market returns to correct for “smoothed”
hedge fund returns (Asness, et al)
• Other portfolios—bonds, currencies, commodity
and security straddles (Fung and Hsieh)
Hedge fund alphas and betas
Fund
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
Beta High
-0.01
0.06
0.03
0.31
0.17
-0.02
0.06
0.06
0.13
-0.03
0.13
0.05
0.26
0.09
0.19
0.08
0.24
0.005
-0.05
0.07
0.20
Mitchell/Pulvino Riskarb Model
Kink = -0.05
Alpha
Beta Low
0.0061
0.57
0.0057
0.34
0.0052
0.42
0.0052
0.85
0.0074
0.56
0.0048
0.17
0.0066
0.65
0.0115
0.88
0.0036
0.37
0.0059
0.26
0.0083
0.52
0.0131
0.34
0.0040
0.98
0.0030
0.58
0.0038
0.46
0.0050
0.29
0.0039
0.41
0.0109
0.42
0.0080
0.29
0.0068
0.22
0.0119
0
Source: Mitchell/Pulvino, data 1990-98
CAPM
Excess Return
0.0046
0.0048
0.0041
0.0030
0.0059
0.0043
0.0049
0.0092
0.0026
0.0052
0.0069
0.0122
0.0015
0.0015
0.0026
0.0042
0.0028
0.0098
0.0072
0.0062
0.0119
Beta CAPM
0.14
0.12
0.10
0.45
0.23
0.02
0.21
0.25
0.17
0.05
0.23
0.14
0.38
0.17
0.24
0.13
0.30
0.11
0.02
0.10
0.18
Alpha CAPM
0.0019
0.0046
0.0037
0.0016
0.0061
0.0040
0.0026
0.0068
0.0027
0.0038
0.0050
0.0103
0.0016
0.0015
0.0027
0.0036
0.0021
0.0081
0.0064
0.0061
0.0122
Problems
• As factors increase in number, run into too
few data points per parameter
• Things (betas, alphas) change through
time (Fung, Hsieh, Naik, Ramadorai)
• But, may not need so many factors—for
consistent estimation of alpha, need to
include only risks that investors care about
Finally
• Even if we knew all alphas, betas and R2’s , this
does not say how much an individual
(organization) should invest in a hedge fund—
this depends upon “preferences”
• At least knowing the betas gives an idea of how
hedge funds fit into rest of portfolio and how to
manage risk with other securities
• Quantitative estimation might be helped by
qualitative information from hedge funds
Questions I
1. For Steve Nesbitt
–
A quantitative analysis of performance provides, in
addition to alpha, betas with respect to various
risks. How do you use this information to advise
clients on hedge fund allocations? Perhaps you
could also talk a little about “portable alpha.”
2. For Don Fehrs
–
What information do you get from hedge funds in
addition to past returns? What are the important
qualitative inputs to deciding to carry (or drop) a
hedge fund? Has there been much change in your
portfolio of funds over time?
Questions II
1.
For Gary Brinson
–
2.
It appears that the contract between investors and hedge
funds has been fairly standard, and is based on returns rather
than on “performance” as we have been discussing the term
today. Do you see this practice as persisting, or might we see
“alpha compensation?”
For Girish Reddy
–
Fund of Funds (FoF) growth has been rather remarkable
(Steve Nesbitt reports that FoF’s held 36% of hedge fund
assets at year end 05, compared to 17% in 00) Three
developments could lead to a reduction in the attractiveness of
paying a fee to FoF’s: increased investor sophistication,
intermediation by consultants, development of multi-strategy
hedge funds. What do you think?