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The Hedge Fund Index Consistency Index (HFCI)

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Table of Contents

1. Overview and Objective

2. The Hedge Fund Consistency Index is Divided into 3 Main Series of which are divided into 3 Sub-Series

3. Description of The Hedge Fund Consistency Series (HFCI)

4. Formulas for The Hedge Fund Consistency Series (HFCI)

5. 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

 

 

Overview and Objective  Back to Table of Contents

 

The general purpose of the Hedge Fund Index Consistency Index (HFCI), the Prevailing Return Index (PI) and the Prevailing Reward to Risk Index (PRR) is to identify funds that merit further investigation for potential investment.

 

These indices are not meant as a recommendation or prediction of future results. Each index and the indices as a group are offered a research tool as part of the research process and not as a direct recommendation for specific investments.

 

We have created the 18 key Indices / Rankings for the purpose of screening and highlighting funds for the investigation that an investor might not otherwise have found or appreciated. The evolution of these indices is based on the fact that every index has pros and cons in their usefulness.

 

Every index will highlight interesting funds but are also flawed in that they may overlook interesting funds that may merit investigation and or include funds that are not worthy of investigation.  These indices are no exception. 

 

However, each index tries to include a formula that resolves flaws or at least provide a ranking that a related Consistency Indices and Prevailing Indices may fail to achieve. As a group, the 18 indices strive to reveal the maximum number of interesting funds worth investigating. The goal is that as a group, investors will find interesting funds that they may not have found elsewhere and or at provide new insight on a fund the investor heretofore previously looked at.

 

In this regard, each of the 18 indices attempts to do accomplish three things,

(1) Highlight interesting funds at large

(2) Highlight funds that were not in the other 17 indices.

(The reader will find an overlapping of results from the indices but also funds that do not appear other indices but may be worthy of investigation.)

 (3) Reverse engineer a ranking formula that screen for funds investors are interested in.

For example, regardless of how long a record spans, most investors will disregard a fund if it has not performed well in the most three years. The ranking formulas distinctly reward positive performance from the inception of the fund and distinctly for the most recent three years. In the HFCI, it also enables the readers to efficiently compare funds of different track lengths.

 

 

 

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   The Hedge Fund Consistency Index is Divided into 2 Main Groups of which are divided into 3 Sub-Series

 

1. Hedge Fund Index Consistency Index (HFCI), focused on the reward to risk consistency of the record and the most recent 3 years.

   1. From the Inception of the fund's record (comparing funds of different track lengths)

      1. All Funds

      2. Low Vol Funds

      3. High Funds

   2. Performance for the Last 10 years

      1. All Funds

      2. Low Vol Funds

      3. High Funds

 

The Description: Back to Table of Contents

 

Hedge Fund Consistency Index Series (HFCI)

 

Overview

 

The purpose of the HFCI is to identify which funds have been the most consistent on a reward to risk basis over the course of their track record in the near term, specifically the most recent 3 years. One unique feature, that is designed to compare returns of funds with varying lengths of track records.

 

The notion is that all other factors being equal (such as annualized return), each year a fund has achieved performance in extending their track record, is significant. The simple notion in most elementary terms is that all other performance factors being equal a longer performance is more significant than a shorter record. Certainly, no one would challenge that notion.

 

However, the problem is that attractive shorter-term results will often stand out and unwittingly push out this basic intellectual and objective understanding. Secondly, there is no easy way to compare the performance of different length records, because rankings are typically compared for like periods. If, for example, one fund prevails in the 3-year rankings, but upon further analysis was dismal in the prior seven years, it would be effective to screen that out on the initial ranking as the HFCI attempts to do.

 

 

• The Hedge Fund Consistency Index (HFCI) for All Fund Categories. This index uniquely compares the consistent reward to risk returns of all funds of different length track records by rewarding the ranking score of funds with longer records. For example, in the instance of two funds with the comparable return, drawdowns and standard deviation, the fund with the longer record will be rewarded with a multiplier on its ranking score with the formula: ((# of months -36)/100) +1.

 

This multiplier increases the score (of course eventual ranking) for each year or portion thereof that the fund exceeds 36 months or 3 years. The notion is that once a fund attains a 3-year record it is to establish a meaningful record. This formula does 2 things. One it rewards a track for its length, but it also does not exclude a shorter record for comparison. The index also evaluates the reward to risk from inception and the most recent three years, thereby comporting with the desire of the investor looking for both strong long term and nearer term performance.

 

• The Hedge Fund Consistency Index (HFCI) for Funds that Employ Low Vol Strategies The thesis of comparing these funds exclusively together is predicated on the notion that the reward to risk characteristics of low vol strategies tend as one would expect exhibit lower volatility but at the same due to their trading style may possibly implicitly indicate greater possible outlier volatility that is incongruous to all or the majority of their record.

 

For example, a trader sells may sell many way out of the call options on the S&P. Invariably, these options will expire worthless and the option seller’s track record will appear low and viscerally may appear to be “low risk”.  However, in an outlier market condition in which the market spikes inversely precipitously up, the fund manager may experience extreme volatility or losses that would otherwise be extremely out of character of its heretofore low vol history. The top-ranked funds in the “low vol” as one would expect exhibit less vol and maximum drawdown that the “high vol” funds.

 

However, the notion here is that “low vol” funds may not necessarily provide lower risk than “high vol” funds but a different type of risk. 2008, for example, was a rude awakening for many investors who were in “low vol” that were believed to be lower risk. The other question that this stirs up, in which category, the “low vol” fund or high vol fund category is most likely to replicate successful returns going forward. The point here is not to throw shade on “low vol” funds but rather that an investor considers the implications of each investment type in constructing a diversified portfolio.

 

1. The Hedge Fund Consistency Index (HFCI) for Funds that Employ High Vol Strategies.  The thesis of comparing these funds together is predicated on the notion that while these funds generally exhibit greater volatility than funds trading “low vol” strategies, larger drawdowns are generally not such as incongruous departure as in the funds that employ “low vol” strategies. Certainly, funds in this group can and do experience outlier volatility but the point here is that this vol exhibited in this group is more likely to indicate the risk for those who are at least initially relying on the track record of the fund.

2. The Hedge Fund Consistency Index (HFCI-10 Yr) for All Fund Categories for the last ten years for funds with at least 10-year records.

3. The Hedge Fund Consistency Index (HFCI-10 Yr) for Funds that Employ Low Vol Strategies for the last ten years for funds with at least 10-year records.

4. The Hedge Fund Consistency Index (HFCI-10 Yr) for Funds that Employ High Vol Strategies for the last ten years for funds with at least 10-year records.

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The Formulas for The Hedge Fund Consistency Index are:     Back to Table of Contents

 

Hedge Fund Consistency Index Series 

1. The Hedge Fund Consistency Index (HFCI) for All Fund Categories. Index formula: ((return above 5% annualized return)/ Annualized Standard Deviation)+ (return above 5% return)/ Maximum Drawdown)+ (3 year annualized return above 5% return)/ Annualized Standard Deviation)+ (annualized above 5% return)/ Maximum Drawdown)) * ((# of months -36)/100)+1 .

Note: Maximum Drawdown and Standard Deviation are for the entire length of the track record.

1. The Hedge Fund Consistency Index (HFCI) for Funds that Employ Low Vol Strategies.  Same as above applied to only funds that Employ low vol strategies.

2. The Hedge Fund Consistency Index (HFCI) for Funds that Employ High Vol Strategies.  Same as above applied to only funds that employ high vol Strategies.

3. The Hedge Fund Consistency Index (HFCI-10 Yr) for All Fund Categories for the last ten years for funds with at least 10-year records. However, Maximum Drawdown and Standard Deviation calculations included are for the entire length of the track record.

4. The Hedge Fund Consistency Index (HFCI-10 Yr) for Funds that Employ Low Vol Strategies.  Same as above applied to only funds that Employ low vol strategies. However, Maximum Drawdown and Standard Deviation calculations included are for the entire length of the track record.

5. The Hedge Fund Consistency Index (HFCI-10 Yr) for Funds that Employ High Vol Strategies Same as above applied to only funds that employ high vol Strategies. However, Maximum Drawdown and Standard Deviation calculations included are for the entire length of the track record

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Key characteristic 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 regarding the length of track record.

   • The Index compares track records of different lengths. It rewards the index results to the extent the fund exceeds 36 months. This targets direct screening comparisons  / of funds with different 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 will screen higher. At the same time, funds with shorter but exceptional performance will more also appear for review.

2. LOW VOL FUND STRATEGIES: The Indices That 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 implicit risk than High Vol Strategies.

   • Low Vol Strategies tend to produce, smoother returns, ie. “Low Volatility” for extended periods of time but may be subject to sudden and unexpected noncontiguous, 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.

   • While Low Vol Strategies exhibit less vol than High Vol Strategies, they may possess different types of risk. This may be obvious to sophisticated investors but across the spectrum of investors, there is a visceral tendency to assume that Low Vol strategies are less risky. Certainly, High Vol strategies may also contain outlier risk. However, the apparent volatility that is generally seen on a monthly basis may at least to the casual observer be more indicative of risk. Also, the author raises the question if the likelihood to replicate future returns with High Vol strategies might sometimes be counterintuitively greater than Low Vol Strategies.

   • Back to Table of Contents

 

Arguably the most important question an investor should attempt to ask about a fund’s strategies and the people who run the fund is whether past returns or at least meaningful proximity of past returns can be replicated. Long term positive compounded the returns is, of course, the goal. And for the purpose of making a point but not attempting to be snarky, the goal is not low vol funds that eventually incur outlier risk or flatten out because the strategy was difficult to apply or adapt to unanticipated market conditions. The point here is again, is not promote one style over another style. Far from it. Rather, the investor needs to look below the hood in assembling a diversified portfolio that has the potential to replicate past returns while collectively protecting equity.

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   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 risk 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, this the drawdowns are generally less of an asymmetric surprise than the low vol group that has 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 inherent before investing and arguably is investing with eyes more wide open with respect to risk.

 

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.

 

On a slightly tangential but interesting point, with respect to drawdowns for both groups, no one likes them and generally, they are not looked upon in a positive manner. However, it can be argued that the real investment is not so much the total money initially invested but the real investment is incurring drawdowns.

 

The supposition here is that every trader/strategy has to find the trend and or capitalize on the specific trading opportunities. If successful trading is the result of achieving a critical percentage of successful trades, that means an investor has to invest in the expense of all trades including unsuccessful trades and periods.

 

Of course, all other points being equal, every investor rightly wants a fund that minimizes vol and drawdowns. We get that and it is not an objective to be abandoned. But investors in the pursuit of protecting equity need to be wary of funds so committed to the protection of equity they squash the ability to produce future returns.

 

To a point, drawdowns are the expenses or investment in building a business. Every business or trader, of course, wants to keep expenses low. But if the expenses or investment is too low, it is difficult to build a business.

 

   4. The Comparison of “Low Vol” strategies vs “High Vol” strategies. It is the author’s opinion that low vol funds do not necessarily have a lower risk than high vol fund strategies. They often are subject to exogenous or outlier events that appear to cause to be sudden volatile aberrations and drawdowns. The point is the low vol funds have different risk than high vol funds and not necessarily a lower or greater risk. Risk can be reduced by skill, intelligence, and proper personnel and resources. However, in the comparison of Low Vol risk vs High Vol risk, it cannot be eliminated. All other points being equal, it is like moving the “risk” bulge in a water hose from one section to another section. The risk in that scenario is that pressure builds up and explodes. The high vol water hose, on the other hand, has many more apparent “vol -risk” bumps and irregularities that are more visible over time. Both styles have a place in a portfolio seeking to diversify risks and exposures.

 

 

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

  3. 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.

  4. 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. It may be seen as “unfair” on the surface. 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 not find) and hope to achieve going forward.

  5. On the issue of the drawdowns, the following comprise what we believe are some interesting thoughts to consider:

    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 – with respect to drawdowns we wish to include all drawdowns with the intention to increase the indicatives value of past drawdown.

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 I 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 at all in the particular fund.

3. The drawdown history also may provide a basis for scaling into a fund. If markets and also inevitably funds as well are cyclical, arguably it may make sense to hold some back to invest after a drawdown. The arguments for scaling into a fund are implicit and broadly well-known but perhaps not employed as often as it should be and we believe worth stating here:

   1. If a fund recovers from a historical drawdown and then proceeds to generate its historical average, it is a statistical incontrovertible fact that it will generate outsized returns for the period.

   2. If an investor held back 50% to invest in a drawdown, the investor has also protected their psychology. The investor who did not hold back money for the drawdown may be more inclined to be emotionally distressed prompting him/her to prematurely withdraw. Prematurely withdrawing from an investment can be especially costly in hedge funds. If the money is reinvested in a new fund, it is subject to incentive fees on dollar one. In contrast, there is no incentive on the recovery if the investor remained in the initial fund.

   3. If an investor completes their investment after a drawdown and the fund continues to lose money and the investor is forced to withdraw, they may still possibly lose less money because 50% of the investment was not subject to first 50% of the drawdown.

   4. If an investor has decided to scale in, they still retain the option for other reasons to not invest the remaining the portion of the investment.

   5.  One of the arguments against scaling in is the opportunity risk. The fund may make money before the investor completely scales in. However, the counter arguments are:

      1. that over a reasonable period of time, there are a number of good funds experiencing drawdowns,

      2.  drawdowns are inevitable and funds are subject to the inexorable cycles of ups and downs inherent to the markets and trading

      3. Scaling is another way to diversify. Scaling in is a way of diversifying an investor’s entry across diverse market conditions. Why concentrate one's risk in the market conditions present at the time of investment?

      4. Keep in mind, many investors who otherwise may profess that it is not important to scale on the cyclical nature of trading, often are unwittingly are scaling in on perhaps the less favorable side of the statistics. That is investors tend to invest after a manager or fund has had a great run. However, it is not surprising that many investors feel that as soon as they invest the fund (or market ) goes down.

      5. Our experience has been, that in discussions with a trader during the drawdown, they will share the fact that they just added to their fund. So if the people who trade funds, act this way, what does this tell us?

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    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 is 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 as part of reverse engineering a screen for funds we believe investor want

1. This 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 show extraordinary reward to risk characteristics. Taking average return divided by the maximum drawdown ratio, for example, the ratio would be fifty to one and otherwise 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 a hedge fund.

 

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