Financial Education

When measuring hedge fund performance, one simple tool is to look at average gains and losses for periods.

The average gain considers only periods in which there was a gain, and is the simple average return in those periods. Likewise, the average loss is the simple average return in all periods in which there was a loss.

The gain to loss ratio is the average gain divided by the average loss.

What the gain to loss ratio does not tell you is how many periods realized gains and how many realized losses. It also fails to account for compounding of returns.

Investors are required to hold for a specified time and provide a specified advance notice before redeeming. These restrictions permit the manager to take a longer-term point of view and invest in less liquid securities.

Hedge fund fees typically include a fee based on the amount of assets being managed and a fee based on the fund’s performance. The performance based fee is typically 20% of the performance in excess of some minimum target. So, for example, a firm with $100 million in beginning assets is expected to earn at least 2% per quarter, and in a given quarter their return is 3% ($3 million.) Their performance based fee would be 20% of the difference between the $3 million actually earned and the $2 million (2%) minimum requirement – or $200,000.

If, in the following quarter, the fund loses money and returns to $100 million in assets, obviously they would not earn a fee in that period. However, investors would also be reluctant to pay a fee for the fund simply recovering the $3 million lost. After all, they already paid a performance fee when the fund reached $103 million the first time.

As a result, fund structures typically include a “high water mark” provision. This provision stipulates that the fund cannot charge additional performance fees until the previous high value has been surpassed.

In order to keep investors from seeking a “free ride” by investing in funds that have recently suffered a loss in order to avoid performance fees until the high water mark is recovered, most funds employ accounting methods known as fee equalization to ensure that all investors in the fund are charged incentive fees on an equitable basis.

Most hedge funds charge 1-2% as a management fee plus 20% of net profits above a hurdle rate. Losses must typically be recouped before additional performance fees can be paid.

In addition to self-selection bias, hedge fund databases can be prone to sample selection biases.

Most databases only include funds that meet certain criteria (size, track record, etc.) Very poor managers will not survive long enough to be tracked.

Furthermore, some databases include funds of funds or managed futures, while others do not. This effects comparability across databases.

A previous article noted that hedge funds tend to be fairly secretive, and discussed some of the reasons for that.  However, both investor pressure and the threat of regulation have led hedge funds to be somewhat more transparent over time, even if only selectively so.

One way for funds to be more transparent is to disclose risk factors rather than specific positions. Thus, the hedge fund could say they have exposure to equities, interest rates, volatility, or other factors without noting specific positions. Investors are able to learn important information about their investments, including what types of risk they may need to diversify or hedge, but competitors do not get information they could use to either piggy-back or front-run the hedge fund.

A target rate of return that is not based on market returns. It could be a specific return, such as 10%, as opposed to exceeding the return on the S&P 500.

Hedge funds can choose to report their results to database providers who report the overall performance of hedge funds in various categories.

Since performance disclosure is voluntary, peer performance is not a reliable measure. Poor performing managers are not likely to disclose performance (biasing performance upward) and large established managers may not want the trouble (or may want to make their performance stand out rather than be averaged into the peer group.) The aggregate effect is probably that database returns are overstated.

Hedge funds are sometimes criticized as lacking transparency. There are a number of reasons for this.

For one thing, they are privately organized entities with minimal regulatory oversight. They are not required to disclose their holdings and strategies, so they do not.

Closely related to the lack of regulation is the fact that they are only marketed to qualified investors – those who presumably have both the sophistication to understand the strategies and the capacity to accept losses. These qualified investors may be able to glean information about the fund, but public investors, who are not able to invest in the fund anyway, are not.

Perhaps the most significant reason, however, is competitive secrecy. Hedge funds are competing both for investment funds and for investment opportunities. They often employ sophisticated techniques that could be compromised if they were widely known.

Hedge funds are not subject to investment restrictions and thus have greater breadth of investment instruments at their disposal. These typically include leverage, short sales, derivatives, and concentrated or illiquid positions.