Forget Peer Groups And Indexes; Hypothesis Testing Will Revolutionize Due Diligence For Hedge Funds

Monday, August 26, 2013 13:20
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Forget Peer Groups And Indexes; Hypothesis Testing Will Revolutionize Due Diligence For Hedge Funds

Tags: alternative investments | Due Diligence | hedge funds | investment strategies

With a perfect financial storm brewing, it’s likely that more investors will turn to hedge funds as an alpha alternative to conventional investing strategies built on stocks and bonds. It’s time for advisors to stop relying on biased data based on peer groups and indexes and switch to a science-based system of performance evaluation.

 

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Peer into the Future of Hedge Fund Evaluation: Send in the Clones from Ron Surz on Vimeo.

United States equities have reached new highs, skyrocketing more than 100% since May 2009, as bond yields remain near historic lows. Stir in the federal government’s humongous budget deficit and the imminent tapering of the Federal Reserve’s quantitative easing program and we’re looking at one rocky future. No wonder it’s a bull market for investment alternatives, especially hedge funds.
 
The demand for these products is sure to increase substantially in the years ahead as the crowd grapples with the harsh reality of the future. But separating the alpha wheat from beta’s chaff is crucial in the business of intelligently selecting hedge funds.
 
In the future, we won’t pay much for exotic hedge fund betas (risk profiles), but the market will continue to put a premium on superior human intellect. We’ll know the difference because we’ll abandon simple-minded performance benchmarks like peer groups and indexes, and replace them with smart science.
 
Prudently choosing hedge funds demands a higher standard than the traditional methods. Hedge funds, after all, are unique. Products in the same strategy are usually galaxies apart when it comes to management details.
 
That unique quality is also the primary reason why a robust due diligence process is essential. The definition of unique is “without peers,” which means that a distinctive hedge fund can’t be squeezed into an artificially defined group. “Unique” and “peer” simply do not play well together. Hedge fund managers win or lose against peer groups because they are different, not because their strategies are better or worse than quasi-comparable strategies.
 
No one wants or needs to pay for exotic betas that can be reverse-engineered (replicated). In sharp contrast, everyone is willing to pay for that critical factor that can’t be synthesized: superior human intelligence and wisdom that engender profitable decisions by way of savvy investment choices.
 
Yes, we should be prepared to pay a fair price for brainwork, commensurate with the level of brainwork rather than the typical “2 and 20” fee. But first we’ll need a robust model for deciding who is truly delivering performance in the hedge fund universe.
 
There is an alternative to peer groups that is totally unbiased so you and your clients make better decisions, and it’s far less expensive than the universes you’re currently paying for. Performance evaluation is a hypothesis test, and hypotheses are tested by comparing the actual outcome to all of the possible outcomes. That’s exactly what we’ve done to replace peer groups. Portfolio Opportunity Distributions (PODs) create all of the portfolios the manager could have held, selecting stocks at random from the manager’s benchmark. You then compare what actually happened to all of the returns that could have happened, and you can be confident that your inferences are not contaminated by the host of biases in traditional peer groups.
 
Check out our Oscar-worthy hedge fund movie for a brief, fun and enlightening look at why hypothesis testing and cyberclones will revolutionize due diligence.
 

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