Hope is not an investment strategy — especially when it comes to investing in hedge funds. And yet many investors, following the tenets of Modern Portfolio Theory, have come to rely on trust and short-term performance as their primary criteria for selecting hedge fund managers.
Although well established for the evaluation of traditional investment strategies, MPT has proven largely inadequate when applied to alternative investments. Hedge funds, because of their limited transparency, have largely prohibited analysts from verifying the appropriateness of particular benchmarks, which is critical to the MPT analytic process. Poor benchmarking results in inaccurate calculations of alpha and beta and, in some cases, can lead to unrealistic and unsustainable performance expectations.
To effectively employ MPT, the investor and portfolio manager must agree on a suitable yardstick. Such has been the case for decades in the highly transparent world of traditional investing, where clearly defined investment mandates make MPT a reliable tool. As a result, MPT has long been used to explain everything from performance and volatility to style drift and investment policy compliance.
The pitfalls of naive benchmarking were broadly revealed during the 1980s when investors learned that performance tracking errors were more often the result of a manager’s style bias than a lack of competency. The style debate aside, MPT simply doesn’t work for hedge funds. Although high R-squareds — which measure how closely a portfolio’s performance is correlated with that of a benchmark index — when accompanied by positive alpha, have long been used by traditional investment managers as evidence of superior skill, lower R-squareds have been used by hedge fund managers to claim uncorrelated returns. Frequently, however, low correlations have revealed the difficulty of establishing and verifying proper measurement standards because investors lack the granular knowledge of the leverage and trading activities of their managers.
The recent spate of investment frauds — and their overwhelming magnitude — are actually the straw men in discussions of hedge fund transparency. The issues are far broader than simply establishing better operational procedures. The flexibility of hedge fund legal structures, which is generally a good thing for skill-based managers, allows traders to quickly deploy leverage, shift exposures and alter geographic, industry or security-specific concentrations. But these factors render the historic, returns-based methodologies of MPT inadequate for real-time risk management. Meaningful performance monitoring is impossible without the security-specific verifications provided by position-based transparency.
To be fair, returns-based Monte Carlo and value-at-risk simulations did forecast many of the problems of 2008 — although it was generally not the funds that were perceived to be most risky that caused the most damage. Returns-based calculations seldom revealed which funds would collapse or what external catalysts would contribute to those disasters. The forecasts proved nonspecific and nonactionable. Without position transparency, investors were unable to match security liquidity with redemption terms, and investors were frequently trapped in gated funds. Similarly, investors were unable to independently implement hedging strategies or ensure risk budget compliance.
The lessons of 2008 will not be quickly forgotten. Institutional hedge fund allocators have been severely damaged; well-established funds of hedge funds have experienced large redemptions; and the tragedies of fraud continue to impact many.
Fortunately, good solutions are available. Position-based transparency and risk reporting are becoming more widely accessible and are no longer optional luxuries. Position-based reporting, based on the comprehensive analyses of individual holdings, is being integrated with returns-based MPT to create the new standard, both at the fund-specific and aggregate portfolio levels. MPT, or even returns-based Monte Carlo and VaR, is not reliable on its own. Gross and net exposures, countries and sectors of risk, individual security concentrations and active hedging must be monitored with confidence. Investment policy compliance can only be accomplished with the support of robust transparency systems generating high-frequency, actionable reports. Managers that resist this trend will, over time, become less eligible for meaningful allocations from institutional investors.
The good news is that performance is likely to improve with the implementation of better risk controls. Transparency will also lead to greater investment conviction and larger allocations to superior, skill-based managers. Investors will increasingly learn to use more granular data to implement overlay strategies to manage unwanted exposures. Risk budgets will be better enforced. In the end investors will sleep better knowing that their absolute-return objectives are no longer inconsistent with their fiduciary duties.
Kenneth Phillips is CEO of HedgeMark International, an investment advisory firm focusing on managed accounts platforms and risk management systems.