The investment management industry is fiercely competitive. As such, in order to distinguish oneself managers need to focus on putting their best foot forward across their entire organization – from front-office investment decision-making to back-office documented transparency. Few hedge fund entrepreneurs possess all of the required skills to make their firm a success. The vast majority are focused on the investment strategy and its related marketing. However, to truly distinguish oneself, hedge fund managers need to also convey a commitment to ensuring the safety and proper treatment of investor capital. Within this spirit this article considers what is appropriate with respect to performance presentation. Falling short in this area can significantly hurt credibility no matter how good the returns that the hedge fund manager produces.
How Managers Get It Wrong
We have come across hedge fund managers that erroneously give prominence in their performance presentation materials to comparing their absolute return investment strategy to a Long-Only equity index. This is a misleading apples-to-oranges comparison and occurs far too often. For managers using absolute return strategies such as Long-Short, equity benchmarks should not be displayed in the core marketing material and should only ever appear in the performance report’s appendix. Some managers continue to use equity benchmarks despite avoiding to invest in certain sectors. This makes the use of long-only equity benchmarks doubly bad. But what takes the cake is comparing Total Returns from a portfolio to the Price Only returns of a benchmark. One manager published a cumulative performance return for the benchmark of 10% when its Total Return over the period was in fact 45%. The former return did not reflect the reinvestment of dividends nor that of other income. In under-representing the benchmark return the hedge fund manager is enabled to masquerade as a huge alpha generator.
It may all end up coming back to bite them as discovered published fallacious returns will lead one to question the quality of all manager calculations. For, if the manager cannot produce correct benchmark returns, how will he be able to calculate more challenging in tandem returns from short and long positions? During the due diligence process investors want managers to be forthcoming about any shortfall in their operational skillset. Without that it can be difficult for the investor to determine whether the manager is purposely misleading or simply naive about the intricacies of performance reporting. No matter, the lack of acknowledgment by the manager will lead the investor to strike the manager off his list.
What Investors Need
We would also point out that hedge funds indexes such as those produced by HFRI simply offer a peer group comparison rather than an objective measure of the performance of the opportunity set. Heisler & Nipp (Jeffrey C. Heisler, 2016) point out that these “peer group comparisons” are prone to both selection and survivorship biases. They also point out that many are made up of a wide disparity of investment approaches and manager characteristics. We advocate that hedge funds managers measure themselves against a risk and return metric such as the Sharpe Ratio, and more specifically the Modified Sharpe of Conditional Sharpe ratios. Investors allocate a certain percentage to hedge funds (usually 5-10%) in order to increase overall wealth returns without increasing overall risk.
The CFA Standards of Practice Handbook states in III (D): “When communicating investment performance information, Members and Candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.” As such, hedge funds should only publish the correct total return benchmark returns in the supplemental information section of the performance report. Managers should spend more time on detailing risked-returns. As well, the valuable insight gained by displaying hedge fund correlations with large benchmark such as the S&P 500 should also be included most appropriately in the supplemental information section. When it comes to performance reporting hedge funds should heed the advice of those that know better or else risk looking bad and uncompetitive.
Jeffrey C. Heisler, P. C. (2016). Topics in Investment Manager Selection. CFA Institute, 101.PDF version