Proper benchmarking: What I learned as a hedge fund manager
08 January 2019 | Portfolio construction
Commentary by Chris Tidmore, senior investment strategist in Vanguard Investment Strategy Group in the United States.
For a decade or so before joining Vanguard, I managed a hedge fund. Over the years, I've had a multitude of conversations about how to properly benchmark hedge funds and other alternatives. Many investors have a well-thought-out rationale for how they do this, but others do not. So today I'm going to share with you the secret to improving the relative performance of hedge funds—or any investment for that matter—through proper benchmarking.
The fund I managed used an event-driven strategy, with a primary focus on merger arbitrage. Specifically, merger arbitrage is designed to capture the risk premium associated with potential deal failure in corporate mergers and acquisitions. Take a look at how merger arbitrage, and a few other popular categories of equity hedge fund strategies, have performed relative to the Russell 3000® Index over the last ten years.
Inappropriate benchmarks can lead to inappropriate conclusions
Growth of $1 in three common hedge fund strategies
Notes: Merger arbitrage, equity market neutral and long/short equity categories represent the returns of the HFRI Merger Arbitrage Index, HFRI Equity Market Neutral Index and the HFRI Equity Hedge (Total) Index, respectively. Russell 3000 Index returns are gross of fees, while HFR® returns are net of fund fees.
Sources: Vanguard calculations, using data from Hedge Fund Research, Inc., and FactSet Research Systems, Inc.
Not particularly compelling results, right?1 An invested dollar would have grown much more if indexed to the Russell 3000. However, I'd argue that the figure above uses an inappropriate comparison to assess the returns from these strategies. While some private alternatives should be benchmarked to a long-only equity investment, many should not. Benchmarking is the primary way we as investors evaluate the relative performance of any investment, and with a category as complex as hedge funds, their benchmarks should be carefully chosen.
Formulating a benchmark for a complex investment strategy can often be a blend of art and science, though a good benchmark should have at least the following characteristics:
- Measurable—it should be straightforward for an investor to determine the return, and relevant performance statistics, for a given benchmark.
- Tailored to the risk characteristics of the specific strategy—an appropriate benchmark should match the level of risk taken by a particular strategy in addition to any major constraints for the manager.
- Investable—an investor should be able to achieve the return from a benchmark as an alternative to the investment option it's being used to measure.
Let's focus on the second point—tailoring to the risk characteristics of the particular strategy. In doing so, we'll create more appropriate benchmarks that are both investable and measurable. By regressing the average monthly excess returns of each hedge fund strategy on the monthly excess returns of the Russell 3000 Index, we can find a reasonable approximation for each strategy's sensitivity to long-only equity risk.2 The three equity betas from these regressions for merger arbitrage, equity market neutral and long/short equity, respectively, are 0.13, 0.10 and 0.49 over the ten-year horizon 2008–2017. The three strategies all invest in equities but have less long equity exposure than you might think. Clearly, the Russell 3000 was an inappropriate point of comparison.3
Because these three strategies broadly seek to generate absolute returns, or positive returns that are uncorrelated with traditional asset class returns, we use intuition to guide our benchmark construction. Instead of solely the Russell 3000, let's measure the excess returns of these three strategies against portfolios containing a blend of equity and a risk-free rate proxy over the same time period. We'll match our equity exposure for our custom benchmark portfolios according to the regression betas above.
Hedge fund strategies appear more successful relative to suitable benchmarks
Cumulative excess returns of three common hedge fund strategies
Note: The risk free rate proxy is the Bloomberg Barclays 1-3 Month Treasury Bill Index.
These results look a bit different, don't they? After adjusting the strategies for their various equity exposures, the long/short equity return series still underperformed, while merger arbitrage and equity market neutral showed notably improved relative performance. While other exposures may better help to explain the returns from these strategies, you can see how simple it is to present a case for and against hedge funds just by using a different (relative) performance measurement process. And though we use this type of investment analysis to specifically assess hedge funds here, it is broadly applicable to any type of active strategy—including traditional active and liquid alternative mutual funds—where matching risk characteristics is particularly important to the performance evaluation process.4
Benchmarking is the basis of performance assessment. It is important to hold managers accountable for using the right yardstick to evaluate portfolio performance.
Note: Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
I'd like to thank Dan Berkowitz for his contributions to this article.
1 The comparison happens to be particularly unfavourable to hedge funds given the strength of the equity market run over this time period.
2 Returns in excess of a risk-free rate proxy, the Bloomberg Barclays 1-3 Month Treasury Bill Index. Though hedge funds in each of the HFR indexes may hold global equity securities, running the analysis using a broad-based, global equity benchmark, such as the FTSE Global All Cap Index, does not alter the regression betas significantly. They are 0.12, 0.09, and 0.47, respectively.
3 Another important characteristic of a good benchmark is that it is decided upon in advance. Here, our analysis is run ex-post, and I wouldn't have been able to tell you as of January 1, 2008, exactly what the equity betas for each of these strategies would be over the ensuing ten years. There's a theoretical component to this exercise, but nonetheless, custom benchmarks are a better starting point than a broad equity market benchmark.
4 To properly specify these types of regressions, the risk factors used should be broadly representative of the risk characteristics of the underlying investments.
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