What Does it Take For You to Lose Money?
Markets rarely go up in a straight line. Hedge fund performance rarely goes up in a straight line. Investors know that and managers know that. So why are managers so reluctant to position their message in a way that acknowledges that?
Just Because Everyone Else Does It That Way…
Nearly all managers paint a generic picture of their fund’s performance. They use broad metrics, hitting surface-level stuff like annualized returns, “best month,” max drawdown, Sharpe ratio over the life of the fund, etc. Or they make sweeping generalities, using terms like, “all-weather,” and uncorrelated to characterize the consistency of returns. That all sounds nice, of course, until they are left struggling to curb redemptions after an unexpectedly large monthly drawdown.
It feels odd to have to suggest that managers do a deeper dive into their own return profile considering the enormous weight most already assign to performance relative to all the other factors that go into the allocation decision. But when an investor starts to dig into a fund’s performance…and she will dig-in if she has any serious interest, she will want a lot more clarity. And managers have a lot to gain by getting in front of this.
What to Expect When You Are Setting Expectations
What investors need to know is how a portfolio will behave under various market conditions. For example, what conditions are most conducive to positive performance – and as importantly – what conditions are most likely to lead to less positive (yes, “bad”) performance?
Take your typical long-only fund. During a period when they market gets smushed, there is little uncertainty as to whether or not the fund lost money. With alternatives products, though, it’s typically not that simple.
First off, a true analysis of fund performance can actually uncover some interesting trends that may otherwise be overlooked. When we slice a hedge fund client’s performance, for instance, we very often see significant outperformance to benchmarks in down markets. Always a datapoint worth highlighting.
Secondly, the transparency related to portfolio behavior may help position a fund as a more genuine fit within an investor’s portfolio. PMs can talk about being uncorrelated with the market all they want, but it doesn’t mean much if their product is perfectly correlated to a target investor’s existing portfolio.
It’s important to appreciate what drives an allocation decision. Often times, the objective is to monetize a view and position for exposure to a particular market or asset class. It’s one of the primary reasons why investors “bucket” investment strategies – it makes it easier to identify and access beta when expressing an opinion. For instance, if you anticipate default risk to rise, you want to know that your investment is making money when you see credit spreads widen significantly.
Finally – providing investors with insights into portfolio behavior will likely save considerable time and headache in the long-run by setting expectations so they are prepared when bad news does hit.
Better to be Disappointed Than Surprised
A long-short quant client of ours recently posted a down month in January – even with the S&P TR up 8%. While losing money is never fun, it’s worth noting that few were actually surprised. The reason – the manager’s have been very clear on their investment strategy – and its anticipated behavior. The fund’s approach is to be long quality value names, and short riskier growth names. Consequently, as the PM points out, the fund is naturally defensive. On a relative basis, it performs best in down markets – and as you may have surmised, actually put up positive number in December when the overall market was down ~9%.
Being transparent about what works in the portfolio and when (the drivers of performance or underperformance) – will go a long way toward aligning expectations. Losing money isn’t the issue – the issue is losing money when you don’t expect to lose money.
By JD David