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The Hedge Fund: Consistency and Prevailing Return Indices Unique Characteristics 

The Hedge Fund Index Consistency Index (HFCI),

The Prevailing Return Index (PI)

The Prevailing Reward to Risk Index (PRR)

 

       Table of Contents

Discussion of Key characteristic of the Indices

  1. Why most of our Indices compare funds with different length track records

  2. Risk and Performance Characteristics and why “Low Vol” funds together.

  3. Risk and Performance Characteristics and why “High Vol” funds together.

  4. Comparison of “Low Vol” and “High Vol” Strategies

  5. Unique Characteristics of how the Indices Compare funds for the Last 10 -Years

  6. Ideas to consider regarding drawdowns

  7. Why the Indices evaluates separately the Most Recent Three-Year Return with longer records in the same index rankings

  8. Why the Consistency Index formulas subtract 5% from the performance 

No intent is made to:

  1. Provide investment advice, 

  2. Recommend a specific fund or type of funds.

The purpose of this article is to explain:

  1. The purpose of the indices

  2. The reasoning behind the indices

  3. The characteristics of each index

 

 

Key Characteristics of the Indices    Back to Table of Contents

  1. The Indices Compares All Funds with Different Length Track Records

    • Objective: The objective of this formula is to screen for the funds that have best performed consistently on a reward to reward risk for the long term and short term regardless of the length of track record.

    • The Index compares track records of different lengths. It rewards the length of the record to the extent the fund exceeds 36 months. This facilitates screening comparisons  / of funds with different track record lengths. Funds with comparable results and with a longer record will screen higher.  At the same time, funds with shorter but exceptional performance will more also appear for review in the same index.

  2. Low Vol Fund Strategies: These Indices Compares Funds with Low Vol Strategies and across Different Length Track Records  Back to Table of Contents

    • Objective: The objective of this formula is to screen for the funds that have best performed consistently on a reward to reward risk for the long term and short term which implement one or more Low Vol Strategies.

    • Low Vol” strategies include:

      • Funds Ranked with Strategies that Include: Arbitrage, Convertible Arbitrage, Credit, Debt, Dividend Capture, Equity Market Neutral, Fixed Income, Lending, Merger Arbitrage, Option Strategies, PIPEs, Settlement, Statistical Arbitrage, Stock Index Arbitrage, Stock Index, Option Strategies, Structured.

    • The reason that Low Vol Strategies are ranked together is that the track records of low vol strategies are often less indicative of their outlier vol than High Vol Strategies.

    • Low Vol Strategies tend to produce, smoother returns, ie. “Low Volatility” for extended periods of time but may sometimes be subject to sudden and unexpected asymmetric, outlier, and extreme volatility or losses.

    • The smooth returns and then unexpected vol is often due to

      • Episodic, Outlier Unanticipated Events or illiquidity Events (or even predicted events with uncertain outcomes) and or such as 9/11 and the mortgage crisis in 2008.

      • Trading errors such as lifting one leg of a hedge not concurrently with another leg at an inauspicious time such as in an arbitrage trade.

      • Complicated short-term strategies may be difficult to replicate over the long term or adapt to changing market conditions. This equates to opportunity risk. Certain Low Vol strategies are hard to replicate over time and may just flatten out to very low or virtually no meaningful return in excess of a risk-free return.

   3. High Vol Fund Strategies: Compares Funds with High Vol Strategies and across Different Length Track Records   Back to Table of Contents

  • Objective: The objective of this formula is to screen for the funds that have best performed consistently on a reward to reward risk for the long term and short term which implement one or more High Vol Strategies.

  • High Vol Strategies include: 

    • Funds Ranked with Strategies that Include: Activist, Balanced (Stocks & Bonds), Closed-end funds, Discretionary, Distressed Securities, Emerging Markets, Equity Dedicated Short, Equity Long Only, Equity Long/Short, Equity Long-Bias, Equity Short-Bias, Event Driven, Fundamental - Agricultural, Fundamental - Currency, Fundamental - Diversified, Fundamental - Energy, Fundamental - Financial/Metals, Fundamental - Interest Rates, Macro, Stock Index, Systematic, Tail Risk, Technical - Agricultural, Technical - Currency, Technical - Diversified, Technical - Energy, Technical - Financial/Metals, Technical - Interest Rates, Volatility Trading

  • The reason that High Vol Strategies are ranked together is that the track records of High Vol strategies may be more indicative of future vol than Low Vol Strategies. Generalizing for the purpose of discussion (but not stating an absolute conclusion), funds that employ certain strategies tend to produce more high vol results. This group can still incur larger drawdowns that are out of character of the pre-existing vol. Nonetheless, the drawdowns are generally less of an asymmetric surprise than the low vol group when it has its asymmetric outlier drawdowns.

 

Certainly, the past performance is not necessarily indicative of future results as we are required to rightly emphasize but at least an investor can often review monthly volatility that is explicit before investing .

 

Having said that, it is also fair to say the biggest drawdown is at least in theory in front of us because the past is finite and the future is infinite. No attempt is intended to project future drawdowns; other than to say it may possibly be more difficult to forecast outlier drawdowns with Low Vol strategies.

 

   4. The Comparison of “Low Vol” strategies vs “High Vol” strategies. Low Vol funds may or may not necessarily have a lower risk  or higher risk than high vol fund strategies but different types of risk. They often are both for example subject to exogenous or outlier events that may be the cause of sudden volatile aberrations and drawdowns. 

 

 

    5. Comparison of Funds for the Last Ten Years The objective and reason for the components of the Ten Year Formula Screening Formula are as follows.  Back to Table of Contents

 

  • Objective: In the early days of the alternative investment industry, the attainment of three-year record was considered a meaningful performance. Now the industry has matured to a point where there are many funds that have produced 10+ year track records and that have been tested across multiple cycles and inflection stress points. The Ten-year rankings are divided into two groups:

    1. Evaluation of the entire record (and the most recent three years) but only for funds that have a ten-year performance

    2. Evaluation of only the last ten years (and the most recent three years) but only of course for funds that have a ten-year performance

      • As would be expected there will be an overlap of rankings between these two groups. However, as discussed, the purpose of each index is to pick up interesting funds that are not included in one ranking and similarly to eliminate funds that do not generally merit in-depth investigation.  For example, 10 years is generally a good length of time to evaluate a fund. If a fund, however, produced an exceptional prevailing compound return over 10 years it may appear highly ranked on the rankings that only evaluate the last 10 years. But if in the prior years it produced terrible returns, it may not appear on the rankings of funds with ten-year histories that are evaluated for their entire history( enabled by the fact that our index facilitates comparison of funds with different length of records). And conversely, if a fund produced lackluster results in prior years but exceptional results over the most recent ten years, there could be compelling reasons to still review the fund.

      • However, even in the rankings of the last ten years, our index formula applies the worst drawdown and the annualized standard deviation across the entire history of the fund even it exceeds more than 10 years. This application may be seen as “unfair” or inconsistent. On the other hand, this is not a contest. The purpose of the screen is to reverse engineer the screening for as many items as possible that investors are looking to find (and avoid) and hope to achieve going forward.

    6. Ideas to Consider Regarding Drawdowns     Back to Table of Contents   All points being equal, each investor wants to find a fund that has demonstrated superior skills at protecting equity.  As discussed, past performance is not necessarily indicative of future results – as the past is finite and the future is infinite – yet with respect to drawdowns, we wish to include all drawdowns with the intention to increase the indicative value of past drawdowns.

  1. It is also as much as possible to understand the fund’s potential for drawdowns in order to decide what is the cutoff point to exit a fund. Too often we have seen an investor incur a large drawdown that is similar to the past drawdown and exit the fund. 

  2. Such investment from the outset was an accident waiting to happen. If a repeat of a historical or even a greater but comparable drawdown should cause an investor to exit, then arguably the investor should not have invested  in the  such a fund to begin with.

    7. Most Recent Three-Year Return.   Back to Table of Contents There is significant emphasis on including the three year returns in the formula because as a practical matter, and for good reason, most investors will not invest in a fund no matter how good its long term record if the fund has not performed well in the most recent years and ideally commensurate with positive results of its long term record.   

 

     8. Why 5% is deducted from Ten-year Average Returns and the Three Average Returns.   Back to Table of Contents

 

The reason for this screen is part of reverse engineering for funds we believe investors want:

  1. That is to screen out the funds that earn a low rate of return. For example, a fund that earned 5% and had the worst drawdown of .1% will appear to show extraordinarily high reward to risk characteristics. Taking average return divided by the maximum drawdown ratio, for example, the ratio would be fifty to one and cause it to be ranked high on any reward to risk scale.

  2. Generally speaking, investors are not looking for funds that make only 5%. At the risk of over-generalizing or overstating the objectives for all market and interest-earning environments, it appears that investors like to earn at least 10% if they are going to accept the risk, fees, minimums and or liquidity conditions of investing in a hedge fund.

No intent is made to:

  1. Provide investment advice, 

  2. Recommend a specific fund or type of funds.

The purpose of this article is to explain:

  1. The purpose of the indices

  2. The reasoning behind the indices

  3. The characteristics of each index