The Story and Logic behind the Consistency Index

 

In the early 90’s we were so impressed that Managed Account Reports (MAR) founded by Mort Baratz and Leon Rose provided a list of the best track records of managed futures traders.

They provided the original “watering hole” for managed alternative investments.

 

Inspired, my colleagues and I offered managed futures traders as managed accounts to investors.

 

However, many clients would tell us something to the effect of, “ I am not like other investors.  I am not trying to hit a home run, I just want to achieve consistent results”. Interestingly most investors held this belief that they were unique in wanting to achieve consistent results vs. "home run" results. As a result, we created the CTA Consistency Index.

 

We mailed postcards to lists of managed futures investors offering them the Top 10 Most Consistent CTAs' Newsletter and immediately we knew that we hit a real need. The response was overwhelming. Then when we posted the rankings on the internet ten years later, in January 2000, expanding it to include Hedge Funds in the Hedge Fund Consistency Index,and again the response was overwhelming; over 50,000 in total.

 

From 2000, we have of course experienced many interesting things such as the:

  • Good, bad and the ugly of hedge funds (and'traditional investments) during the market crisis

  • The benefits and pitfalls of hedge funds vs. Mutual funds particularly in a market crisis

  • A better understanding of outlier risk

  • Maturity of the Hedge Fund industry. When we began, a three-year track record was practically a  cause célèbre . Now we can review 10 to 20-year records and examine funds that have been tested in the most trying market conditions and inflection points.

 

Through it all, our objective has been to identify historically the most consistent records.

 

We now have three Indices:

 

  • The Consistency Index

  • The Prevailing Index

  • The Prevailing Reward to Risk Index

Furthermore, we have updated The Consistency Index

None of these indices are intended or able to predict future return or risk. Rather the objective is to highlight funds with a compelling performance that may warrant further investigation.

Nor are the indices meant to be conclusive in any regard but rather to contribute to the overall conversation, screening and due diligence process of investment research. Past performance is not necessarily indicative of future results. There is no guarantee against the loss of funds.

 

The reason that these indices were created was to:

  • Enhanced the efficiency in identifying funds with a compelling performance that merit further investigation

  • Address  limitations of traditional indices/rankings

 

It has been our experience that to find interesting funds in traditional indices/rankings, we have to pick through a plethora of funds that do not merit further investigation. Or to say in the medical parlance, many false positives.

 

For example, in the typical indices, we find 4 main problems that often render typical ranking screens inefficient and disappointing.

 

  1. Long Term / Near Term results are not comparable, i.e.

    • That is the near results are good, long term results are poor. For example, the 1, 3, and 5 years performance rankings, are often problematic because the prior years of 5 to 10 are often poor.

    • And or conversely, the long results are good, but the near term results are poor. For example, in 10-year rankings, Often the near term such as the most recent 3-year results are often poor.

  2. Low return, very low vol funds skew up to the top of the rankings. Not only will Reward to risk rankings (such as Average Return / Maximum Drawdown), be beset with long term or near term detritus mentioned in the prior two points but funds with so called "Low Vol" strategies  with very low vol tend to dominate and skew the rankings.

    • For example, if a fund has a .1% maximum drawdown, then even if it earns only 4%, its reward to risk will yield it a 40:1 ratio. 40:1 is great but not if the expected return is 4% and that is not even considering any outlier risk which might be implicit in the strategy but often not considered.

  3. Overall returns may be good but wildly inconsistent throughout the years.

  4. Different Length records. It is difficult to efficiently compare the performance of different length track records

 

We created 3 main index groups to address these inefficiencies. To put it another way, we reversed engineered our indices to find funds in which

  1. Long Term AND Near Term results are more compelling than their peers.

  2. Low return, very low vol funds DO NOT skew up to the top of reward to risk rankings.

  3. Consistent funds ranked the highest (on the Consistency Index).

  4. Funds of Differing track lengths can be more efficiently compared.

In brief:

  1. The Prevailing Index “scores” the returns for the last ten year and the most recent 3 years. This addresses the first and second problems in which there is good long term performance but not good short term performance or vice versa.​

  2. The Prevailing Reward Risk Index “scores” the returns for the last ten year and the most recent 3 years on a reward to risk basis. This again addresses the first and second problems above of either good long term reward to risk performance but not good short term reward to risk performance or vice versa.​ Additionally, in its formula, it assigns a minimum of 3% minimum maximum drawdown in the case where it is less so as discussed, an imperceptible drawdown history does not skew the reward to risk evaluation.

  3. The Hedge Fund Consistency Index

    1. Takes into the account the items above but also addresses the consistency of the returns.

    2. And further to the objective of eliminating the skewing effects of low vol- low return funds, in its formula, it assigns a minimum of a 3% annual standard deviation and 3% minimum maximum drawdown in the case where either measure or both are less.

    3. Facilitates the comparing of funds with different length track records.

 

The Hedge Fund Consistency Index

 

Here is the Overview, the Consistency Formula and Further Explanation.

 

Overview

The general objectives are to:

  1. Identify funds that have most consistency produced superior

    •  long term performance on a reward to risk basis (i.e. return to annualized standard deviation and return to maximum drawdown) and

    • Similarly short term performance on a reward to risk basis

  2. Enable the user to compare results of funds with different lengths of track records. The index rewards longer performance by multiplying results of the number of years (less 3 years to exclude rewarding funds with other only 3 year records).

  3. Compare funds in the following 3 categories:

    • All funds

    • Separately Low Vol Funds with strategies such as the following funds because the Low Vol nature of these funds' track record may often be less likely to not reflect potential outlier Vol;

      • 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 

        • Many of these funds will post low return with low vol and maximum drawdowns thus skewing reward to risk ratios. For example, a fund that has a .1% Annualized Standard Deviation and a 5% return would register a 50 to 1 ratio;

    • Separately Crypto Funds:

      • Many of these funds will post such high returns that they will skew reward to risk ratios. For example a fund that has a 7,000% return and a 70% drawdown would register a 100 to 1 ratio;

    • Separately Higher Vol Strategies such as: 

      • 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 Consistency Index Formula

  1. ((return above 5% annualized return)/ Annualized Standard Deviation)+ (return above 5% return)/ Maximum Drawdown)+

  2. (3 year annualized return above 5% return)/ Annualized Standard Deviation)+ (annualized above 5% return)/ Maximum Drawdown))

  3. X (# of months -36)/100)+1)  

 

 

Explanation

  1. Return / Annualized Standard Deviation

    • Logic and explanation for these criteria

      • Return

        • What is the return above 5% return

        • Most investors generally want at least a 10% return.

        • The objective here is to wean out funds that are making ~ 5% or less.

      • Annualized Standard Deviation

        • Is to measure consistency

        • If the Annualized Standard Deviation is less than 3, it is still imputed as 3. This is avoid skewing of the results from low performing low vol funds. For example, a fund that has a .1% Annualized Standard Deviation and a 5% return would register a 50 to 1 ratio; when in fact most investors I believe would prefer a fund that returns 10% with a 5%+ Annualized Standard Deviation.

  2. Return / Maximum Drawdown

    • Logic and explanation for these criteria

      • Return

        • What is the return above 5% return

        • Most investors generally want at least a 10% return.

        • The objective here is to wean out funds that are making ~ 5% or less.

      • Maximum Drawdown

        • Of historical downside peak to trough risk

        • If the Maximum Drawdown is less than 3, it is still imputed as 3. This is avoid skewing of the results from low performing low vol funds. For example, a fund that has a .1% Maximum Drawdown and a 5% return would register a 50 to 1 ratio; when in fact most investors I believe would prefer a fund that returns 10% with a 5% Maximum Drawdown.

  3. 3 Year Return / Annualized Standard Deviation (since inception)

    1. Logic and explanation for these criteria

      • Return

        • What is the return above 5% return

        • Most investor generally wants at least a 10% return.

        • The objective here is to wean out funds that are making ~ 5% or less.

      • Annualized Standard Deviation

        • Is to measure consistency

        • If the Annualized Standard Deviation is less than 3, it is still imputed as 3. This is avoid skewing of the results from low performing low vol funds. For example, a fund that has a .1% Annualized Standard Deviation and a 5% return would register a 50 to 1 ratio; when in fact most investors I believe would prefer a fund that returns 10% with a 5% Annualized Standard Deviation.

  4. 3 year Return / Maximum Drawdown (since inception)

    • Logic and explanation for these criteria

      • This measure is only included if the fund has at least a history of 48 months

      • Return

        • What is the return above 5% return

        • Most investor generally wants at least 10% return.

        • The objective here is to wean out funds that are making ~ 5% or less.

      • Maximum Drawdown

        • Of historical downside peak to trough risk

        • It is noteworthy that this maximum drawdown is from inception and not just from the last 3 years. The logic is that historical maximum drawdown is a more reliable indicator of risk than the last 3 years.

        • If the Maximum Drawdown is less than 3, it is still imputed as 3. This is avoid skewing of the results from low performing low vol funds. For example, a fund that has a .1% Maximum Drawdown and a 5% return would register a 50 to 1 ratio; when in fact most investors I believe would prefer a fund that returns 10% with a 5% Maximum Drawdown.

  • All of the above is multiplied by (# of months -36)/100)+1)

    1. Enable the user to compare results of funds with different lengths of track records. The index rewards longer performance by multiplying results of the number of years (less 3 years to exclude rewarding funds with other only 3 year records).

 

 

The Prevailing Index

 

After 30 plus years of promoting the consistency index, The Prevailing Index and the Prevailing Reward to Risk Indices are new and simple indices that we are posting.

In the intro, I mentioned that the Consistency Index was born of the comments from investors who said: “ I am not like other investors.  I am not trying to hit a home run, I just want to achieve consistent results”.

Now perhaps investors should be saying “I am not like other investors who just want consistency but I want funds that will also prevail over the long run”.

 

I believe the most important question to ask when selecting a hedge fund is: “will the hedge fund prevail over time”? This quest, frequently investors seek funds that are consistent, with lower standard deviation and or have an attractive ratio of historical return to historical risk (e.g. maximum drawdown and standard deviation).

 

This is certainly a reasonable approach which we advocated. However, arguably the most overarching, difficult and important question to ask, is: “will the fund prevail and continue to compound return over time”?

Ironically, many of the funds with the longest records are volatile and have significant drawdowns. I suspect the reasons vary by the fund but include one or more of the following reasons:

 

  1. Funds that appear less volatile do so because they have not been tested over as long a period of time.

  2. More volatility and larger drawdowns may potentially reflect a more simple and replicable strategy. That may seem like an odd statement. Consider Warren Buffet’s drawdowns:

 

 

 

From https://awealthofcommonsense.com/2014/06/warren-buffetts-biggest-losses/

 

Is Warrant Buffet a larger risk than funds with lower volatility? I think Buffet would argue that he invests in companies that are undervalued and/or are projected to grow and deliver a good return. Therefore if the general market goes down, he is still holding a company with a strong basis that will do well over time and despite the drawdown he taking an intelligent risk that will pay off. In contrast, some lower vol track records (such as selling options) may depend on strategies that are the equivalent to picking up nickels in front of the train. Even though the manager may insist he/she is a mile away from the train; at some point in the future the manager might find themselves exposed to much higher risk than they anticipated.

 

The problem is, for example, if a sudden market event occurs, the manager might find themselves a lot closer to the train they realized. Drastic unexpected losses may then occur unfavorably disproportionate to the potential gain. And it may be harder and riskier to recover vs. recovering from losses associated with holding undervalued long positions or overvalued short positions.

 

Regardless of the explanation qualified investors who log in can view which funds have performed the best over at least a ten year period while producing superior returns in the last 3 years. The objective is to identify funds that have performed well in the long term and also the short term on a pure return in the Prevailing Return Index (PI) and in our Prevailing Risk  Reward Index (PRR). The idea is that such a manager who prevailed over 10 plus period may have possibly demonstrated the requisite skills, personnel, and experience to prevail over time in the future. The formula for these rankings are quite simple but arguably telling.

 

Two index formulas for the Prevailing Return Indices are for funds with at least a ten-year record:

   

  1. (Compound annual growth rate (CAGR) since the inception of fund+ Last 3 Year’s CAGR)

  2. (Compound annual growth rate (CAGR) for the last 10 years+ Last 3 Year’s CAGR)

The Prevailing Reward to Risk Index

Two Index formulas for the Prevailing Reward to Risk Indices are for funds with at least a ten-year record:

   

  1. ((Compound annual growth rate (CAGR) since the inception of fund+ Last 3 Year’s CAGR))/maximum drawdown since inception

  2. ((Compound annual growth rate (CAGR) for the last 10 years+ Last 3 Year’s CAGR)) 

 

As always the purpose of these indices is highlight funds may merit further investigation. No ranking is to be construed as a recommendation or meant to predict or guarantee future results. Nor are the indices meant to be conclusive in any regard but rather to contribute to the overall conversation, screening and due diligence process of investment research.

Past performance is not necessarily indicative of future results. There is no guarantee against the loss of funds. Only accredited investors are permitted to view the rankings.