SkyRank Challenges Times Summary of Burton G. Malkiel Study
The Economic Scene article in the New York Times, Thursday, December 9 Business Section, by Alan B. Krueger, “Those lofty reported returns show that hedge funds are more skilled at managing data than managing money, a study says,” summarizes the results of a study by Burton G. Malkiel, a professor at Princeton University. There are numerous inaccuracies and false assumptions in the study regarding the hedge fund industry.
The article implies that the hedge fund industry claims lofty absolute returns and that there is no additional value to a hedge fund investment over traditional investments such as stocks and bonds. While it is true that many hedge funds do produce greater absolute returns than traditional investments, this has never been a claim by any in the hedge fund industry. Instead, the hedge fund industry claims, correctly, that hedge funds seek to reduce systematic or undiversifiable risk through expert trading or money management experience, and thus, higher risk-adjusted returns are produced, or periodic returns adjusted for the volatility of those returns. The point here is that successful hedge funds are able to achieve extremely high risk-adjusted returns not available from stocks or bonds or a significantly diversified portfolio of stocks and bonds from the long-only side.
The authors imply that managers are more concerned about backfilling data than managing money. While backfilling does exist to a small extent, its existence cannot be used to negate the unique value of a hedge fund. For example, from a database of 550 hedge funds provided by AAC, a portfolio of the “best” 20 hedge funds studied from December 2001 – June 2004 produced risk-adjusted returns 7x that of ten-year treasuries and 8x that of the S&P500 1. Such excess risk-adjusted returns over traditional investments, has little to do with the managers’ abilities to manage data or “backfill” the data. That portfolio, the most successful funds as measured by a proprietary algorithm that weights a number of inputs including risk-adjusted returns, never had a losing month over the time period, something rarely seen in traditional investments. This was only possible, because of the unique skills of those 20 hedge fund managers comprising the portfolio, each skill distinct in its own market at exploiting various market inefficiencies. Such skill is the result of years of experience in the various markets, usually from the long and short side, not the result of “managing data”.
The authors state more than 10 percent stop reporting to the database each year due to poor performance. This statement is only partially true. Managers stop reporting data to various databases for two additional reasons, neither relating to performance. (1) They are not interested in reaching out further to additional investors due to reaching strategy capacity, and/or they do not wish to erode returns on existing investors’ assets. (2) Managers tend to be lazy reporters to multiple databases, oftentimes immersed in the job at hand, managing money, and exploiting inefficiencies of the market when such inefficiencies arise. This fact is represented by the S&P Hedge Fund Index, currently comprised of 40 hedge fund strategies. Ten of the forty, or 25% of the hedge funds, do not report to any database, despite having gone through rigorous transparency requirements by S&P and PlusFunds Group Inc., and despite having impressive returns.
The authors state “Clearly, there is a risk in investing in hedge funds that is far greater than the risk of investing in the other asset classes.” The authors are studying the hedge funds with the highest absolute returns, almost always representative of higher volatility. By definition, such hedge funds will be of higher risk, and will demonstrate erratic positive returns over time. By contrast, the successful hedge funds, those with low volatility, and high risk-adjusted returns, will by definition be more consistent over time. In fact, those hedge funds with high risk-adjusted returns are consistently the best performers over time. This is precisely what the hedge fund industry has always claimed: an alternative investment that consistently is able to reduce market risk over time by skilled trading and money management expertise from the long and short side, and representative of high risk-adjusted returns.
1 SkyRank System of Hedge Fund Ratings, AAC Data.
There are numerous inaccuracies and false assumptions in the study regarding the hedge fund industry.
The point here is that successful hedge funds are able to achieve extremely high risk-adjusted returns not available from stocks or bonds or a significantly diversified portfolio of stocks and bonds from the long-only side.
... because of the unique skills of those 20 hedge fund managers comprising the portfolio, each skill distinct in its own market at exploiting various market inefficiencies.