The drivers of hedge fund returns: Identifying risk and alpha

1/20/2011 12:00:00 AM

There is great commercial benefit in understanding the drivers of hedge fund returns. A large volume of academic literature has been published on the drivers of hedge fund performance and performance persistence.

These were published in the late 1990’s and early part of the millennium and discuss the benefits that hedge funds can deliver to traditional portfolios. Most of the published studies in the field, naturally, have been limited in scope to evaluation of flows and returns from commercial databases such as PERTRAC, HFR or CSFB to perform studies of performance relative to peers in the database or relative to a wide range of publicly available variables on markets using stock returns, bonds returns, volatility etc.

Of course, there is also a wide range of high quality white papers and commercial reports on this topic using private databases that comes from either top tier consultants, allocators and service providers, or is generated by in-house research done by direct investors to support their decisions to invest in the asset class. The proposition that hedge funds add value to institutional portfolios is thus well supported and has driven a boom in institutional use of them, not withstanding any slow down or temporary re-evaluation of the proposition post the recent financial crisis. In addition, by most estimates, institutional use of the asset class will continue well into the future, despite any temporary market or even reputational setbacks.

If hedge funds are here to stay, then the next question is where does out performance and alpha come from within the asset class? How can investors find and retain the best managers who outperform their peers?

Identifying managers who employ new or unique strategies or variations of traditional strategies combined with sound risk management is half the battle. The other half of looking for a great manager is more subtle and more subjective. It involves assessment of manager incentives and non-market variables and forecasting how they impact decision making and contribute to returns.

Investors today often employ experienced teams or hire outsourced professionals to assess the impact of managers’ business models on operational risk. Investors also spend a lot of time trying to understand a manager or fund’s board structure, fees, general partner co-investment, employee ownership of the management company, use of leverage, internal controls, valuation process, hurdle rates, transparency policies, compliance culture, choice of vendors such as primes and administrators as well as other non- market variables. The goal of most of this work is to better understand business risk and manager motivation. Investor experience can often play a very important role in determining how incentives and business models can protect against operational, credit or blow up risk - or perhaps, how these variables may impact performance.

Is it possible to perform a quantitative evaluation of how non-market variables not only lower risk but also how they impact returns? It appears that most of the work to date has focused on how these variables minimise risk. There are a handful of academic research papers on how governance, incentives and operational variables contribute to fund returns.

In fact, there was some interesting work published in the Journal of Finance on the topic last year. Vikas Agarwal, Naveen Daniel and Narayan Naik published a paper in 2009 entitled ‘The Role of Managerial Incentives and Discretion in Hedge fund Performance.’ This critically examined how several fund terms and business model components impacted hedge fund performance. The researchers used a large sample of funds from the combined databases of CISDM, HFR, MSCI and TASS. They concluded that managers with option like incentive contracts, higher levels of managerial ownership, those with high water marks, lock ups and longer notice periods did in fact deliver superior performance. As more work is done in the area of business model risk assessment, we may in fact see more quantitative studies, models and new measures that can be used to determine not only how these important variables lower operational risk, but also how they are related to generating returns.

In traditional investing there is a lot of research on the role of governance and incentives on company or share price performance. However, much less of this is done in the world of alternatives and hedge fund investing. Part of the absence of academic literature on business model risk, governance and their correlation to performance may simply be based upon the fact that is it very difficult to gather data about many of these variables. Most of it is privately held after all.

The ability to assess a fund’s performance holistically, from both an investment and a non-investment perspective, inclusive of governance and incentives, is something that the really great hedge fund investors have been doing for a long time. The availability of supporting academic research in this area is certainly a positive trend. Hopefully, it is one that will continue.

Kevin R. Mirabile is Chief Operating Officer at Larch Lane Advisors. Larch Lane Advisors is a fund of hedge funds and a subsidiary of Old Mutual Asset Management. It manages approximately $1.4 billion in hedge fund investments.

Although he is COO at Larch Lane Advisors, Mr Mirabile writes here in a personal capacity, and the views expressed are his own and not those of Larch Lane Advisors.

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