The Long Term Credit Management (LTCM) fiasco of 1998 forced hedge fund managers to open up and they are now less secretive about their methods and portfolios. Nevertheless, many institutional investors are unconvinced. The complexity of some asset classes gives the approach and those managing the funds a certain mystery. Then there is the link between risk and potential return, an issue muddied by some managers’ continued penchant for secrecy. An institutional investor needs to split the two and establish whether an outperformance is the work of a potential Soros or a gambler in form.
Measuring a hedge fund alpha is more complicated than a straightforward long only as the former fund can include shorts and other instruments. This, according to Roddy Campbell, managing director of Cross Asset Management (CAS) in London, makes it vital to understand the manager’s actions and methodology. Only then can you gauge the risk behind the return. Key to understanding the source of returns are the level of leverage, the maximum position size a manager takes, the maximum a manager is willing to lose and the industry concentration, etc. These contribute to portfolio risk and the investor needs to know them to calculate a manager’s skill.
Investors, wary of hedge funds, will be relieved managers have adapted, albeit reluctantly. Successful long only funds happily reveal positions but hedge funds have dragged their feet over disclosing short positions claiming the stakes – ie, potential losses are higher. Nicola Meaden, chairman of London-based TASS investment research, specialists in hedge fund analysis, says the LTCM in 1998 forced a reassessment: “It has made investors much more demanding about what they expect to get from their managers. It has also made the managers much more co-operative. I think they’ve realised they need each other,” she says.
One of institutional investors’ greatest concerns is the portfolio composition. Until recently, managers guarded their positions and speaking recently in London, Philippe Jabre, the managing director of GLG Partners, argued against portfolio transparency, saying it jeopardised competitive advantage. Nevertheless, some managers now show their present positions and, according to Meaden, on a time-lagged basis, managers are now extremely co-operative.
Complementing the portfolio breakdown are figures normally provided by the fund managers. Standard deviation, or the deviation of monthly returns around the mean for the period, is a useful and oft-quoted figure. The mathematical formula sums the squares of the deviations so in isolation the statistic doesn’t distinguish between positive or negative deviations about the mean. The semi-standard deviation (or downside deviation) overcomes this problem by using observations below the mean and this figure brings the standard deviation to life. If it exceeds the standard deviation, the volatility has historically been on the downside; if it is smaller, vice versa.
But, before relying heavily on the statistics, check the sample size and the corresponding time period used for the calculation. As with any statistical measure, the time period has to be substantial to mean anything and a history of less than a few years is likely to mean little. “Since CAS is only 18 months old, it doesn’t report deviations and Sharpe ratios. However, this isn’t to dismiss the figures and as a historical measure, they are useful in the long run,” says Campbell.
Then comes the Sharpe ratio, the average return minus the risk-free return, all divided by the standard deviation. In essence, it is the unit of return per unit of risk. As with standard deviation, the Sharpe ratio needs to be taken in context. For example, it penalises volatile strategies like global macro, since standard deviation is the denominator. Figures are also relatively meaningless for new hedge funds due to the sample size problems above. Maximum drawdown is often quoted and is a useful measure of potential losses. Quoted as ‘peak-to-trough’, it means just what you could potentially have lost had you invested at the peak and sold at the trough. Technically, there is nothing predictive about maximum drawdown although according to Meaden, in her experience, managers rarely suffer a single drastic drawdown. If a manager has registered a figure of 20%, it’s likely to be repeated.
Given the meat of a fund-full transparency and disclosure, and historical statistics, investors can go one step further by assessing the business infrastructure, the quality of the team, the company set up and hierarchy, the quality of business objectives, the business strategy and the counterparty relationships. According to Meaden, many hedge funds mess up the management of the business opposed to the portfolio.
Tass, for example, looks at different prime investment categories within hedge funds to calculate which offer the best risk-adjusted returns. It picks a sector and then a manager. Looking for good business management before assessing the portfolio management may appear peculiar but there is a certain logic. Most hedge fund managers have left asset management companies or trading desks at investment banks where the back up is taken for granted. When a manager sets up independently, as is common, they leave behind a compliance team – IT support, a marketing team, etc. It therefore makes sense to check the organisation of the business. In Tass’s experience, the best hedge funds have two key, distinct managers – the chief operating officer (COO) and the chief investment officer (CIO). The COO looks after the day-to-day running of the business, leaving the CIO to concentrate on managing the portfolio.
Another important aspect is the relationship between hedge fund managers and their counterparties. Take for example, a risk arbitrageur or a merger arbitrageur: “The most important thing for a merger arbitrage specialist, above everything else, is being able to get the borrowers when you need them, at the right price. All else is almost immaterial,” says Meaden. An institutional investor needs to discover what terms the manager is getting from stock lenders. Another useful measure is the economic clout of a manager. Possession is nine tenths of the law and the bigger the backing, the more, say, a manager has on terms.
An investor also needs to gauge the fund manager’s plans for expanding the business. There comes a point where the fund size begins to dilute performance. As the size increases so transaction fees rise and eat into returns. So, some funds specify an upper limit.
A final point on the checklist is whether the manager is running personal money alongside institutional money. Many new hedge funds are started by individuals who have made money either through trading or more traditional asset management. Most institutions check this and some refuse to invest in funds containing private money. After all, there is nothing like vested interests to tame recklessness.

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