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Category Archives: Analyzing performance
More on hedge funds
2009 hedge fund results are maybe +13%, not the +19% reported
I found an article on hedge funds in the New York Times (the information appears to have originally come from Reuters) the other day. It argues that reported hedge fund industry investment results for 2009 are, at +19%–which is not so hot in any event, much higher than the industry as a whole has actually achieved. +13% is more like the real number.
How so? Reporting results to index providers is voluntary. Hedge funds having a bad year simply don’t send in their numbers and are not included in the index. The evidence? The large majority of non-reporters drop off the radar screen after a period of poor performance. Almost no one racks up a history of outperformance and then suddenly disappears.
More research by Malkiel
Anyway, in an (unsuccessful) effort to find the original research article, I turned up some earlier analysis by the same Princeton professor, Burton Malkiel, and a colleague, Atanu Saha of the Analysis Group. Their paper, which appeared in the Financial Analysts Journal, talks about two factors that bias hedge fund index results upward. They are:
incubation bias
1. backfill bias. The equivalent in the mutual fund world is the “incubator fund,” created using practices common in the Seventies but now banned. The idea was to create a mutual fund not open to the public, seed it with a small amount of money and run it very aggressively in the hope of achieving a spectacular one-or two-year record. The fund may well have been given large allocations of “hot” IPOs in an additional attempt to supercharge performance. If the fund showed off-the-charts returns, it would be offered to outside investors. If not, it would quietly be closed.
Although now illegal for mutual fund companies, this practice is alive and well in hedge fund land, according to Malkiel and Sana. Their evidence? –large numbers of hedge funds with good results that only begin to report results after they’ve been around for over a year.
survivorship bias
2. survivorship bias. This is the idea that the weak-performing competitors eventually lose their clients and are forced to shut down. In investing’s version of 1984, their results are then scrubbed from the records–making the “historical” performance of the industry progressively better than what was actually achieved.
Survivorship bias is also present in the mutual fund industry, where unsalable, poor-performing funds are regularly merged with stronger peers in the same fund family. But during the period they studied, Malkiel and Sana found the upward bias to hedge fund results from this factor was almost 4x the effect on mutual funds.
The researchers also found that a staggering 75%+ of the hedge funds that their database contained had disappeared by the end of the seven-year period they studied. No explanation for why this occurred.
the effect of performance fees
I have one thought about this phenomenon–performance fees. Perhaps the single characteristic all hedge funds have in common is their fee structure: 2% of the assets and 20% of profits.
Suppose Smith and Jones decide to create a hedge fund, which they call “S&J.” They raise money and start to operate. In year 1, they’re down 30%. If they started with 100, they now have 70.
They won’t be able to collect the 20% of profits until they have some, that is, until they get back over 100, 43% higher than they are now. That may take two or three years, even in an uptrending market. What do they do?
One option is to close the fund, return the money and reorganize as “J&S.” That way they collect performance fees from the outset (assuming they don’t repeat their S&J performance). Who would fall for this trick, you may ask? A lot of people, apparently. Look at the case of John Meriwether, the Salomon Brothers bond trader made famous in Liar’s Poker.
Interestingly enough, the FAJ article drew a critical comment from a hedge fund manager. I would have expected something along the lines of Mr. Malkiel’s having no actual investment experience or that practitioners of academic finance have about the same relevance–or maybe less–to the real world as deconstructionist literary theorists do to creative writing.
But the critic’s interesting point is that Malkiel doesn’t disclose that he has a conflict of interest. For about 25 years he was a paid advisor to Vanguard, whose main marketing message has been the superiority of passive over active management.
I’ve just updated Keeping Score for November
Here’s the link. or just click the tab at the top of the page.
What makes a down day interesting–even for long-only investors, which is most of us anyway
I’m writing from about 10:30 am to noon, New York time, on Friday October 16th.
Although I have “down day” in the title of this post, I don’t really mean just down days. I mean counter-trend days. But, inevitable corrections along the way notwithstanding, I think the major stock market trend is up and will be up for at least the next year. So I’m satisfied with the title. You’d follow an analogous procedure for an up day in a down market.
What’s important in a down day
It isn’t so important that the day stays down, or ends down. What is important is that some ugly counter-trend opinion that you can study and think about gets expressed in prices.
Two useful tasks
There are two useful things you can do on a day like this:
–you can “read” the stock prices to get an insight into what investors in general are thinking by observing what they are actually doing, and
–you can take your own investment temperature to see how emotionally involved you are in your portfolio or your stocks (that’s a bad thing).
“Reading” the prices
On a day like this, you should expect that short-term investors will take profits in sectors and stocks that have gone up a lot over the past few months. You should expect profit-taking to be especially strong for sectors/stocks that have gone up sharply over the past short while–month-to-date, or even a couple of days.
On the other hand, although they may be dragged down again today with the rest of the market, you should expect stocks that have been poor performers and that people have been selling for an extended period of time to perform better than the averages. After all, for these stocks, a day like today is nothing special.
Actuality vs. expectations
That’s the picture to expect. What you should do is look for sectors/stocks that are not performing in line with the past two paragraphs. Such stocks will probably fall into two categories:
serial clunkers (underperforming stocks that continue to underperform today–usually a very bad sign) and
very strong, continuing winner, stocks (usually a very good sign).
Your intention shouldn’t be to get an absolute, can’t-be-wrong reading on the market, but rather to notice what is happening that doesn’t fit–either with the typical market pattern on a day like this or with your strategy for the market. You may be able to raise your conviction for some ideas and perhaps get an early warning of changes you need to make.
Turning to today’s market,
One thing that really jumps out to me is that although energy stocks have been the best-performing group in the S&P so far this month, and are up as a group almost 10% since the end of September, they’re down considerably less than the market today. Materials, another economically sensitive group, is doing unusually well also, although not performing as strongly as energy. I think the important thing about both these groups is that they are bets on global economic recovery, without having to bet specifically on recovery in the US.
Another is Harley Davidson (HOG). I haven’t owned this stock for years. As I picture it, the company’s customers are almost all Americans. They’re either biker outlaws or aging accountants/dentists who have read On the Road or seen Easy Rider too many times and are trying to relive–or just plain-old live–their youth.
The products are expensive and easily postponable purchases. On the surface, the earnings they reported two days ago were poor. Yet, after an initial dip, the stock was up strongly yesterday and is (so far) up again today.
I’m not really interested in buying the stock, although I’l admit to be contemplating buying a Harley t-shirt. As you may know from Keeping Score, I lost my enthusiasm for the consumer discretionary sector at the end of August. But here’s a consumer discretionary–really discretionary–stock doing well. I’ve looked a F and scrolled through a series of retail names and all are weak today, except TGT and WMT. Everything else seems to fit with a weak US consumer. Still, HOG is a data point I wouldn’t have expected and is therefore worth thinking about. I’ll have to be alert for any similar data.
Another notable stock is WYNN, which I own. It has been very weak over the past week and is underperforming today, too. It’s trading in line with other casinos, but that’s cold comfort. As a group, casinos are now doing worse than hotels. I’m not going to do anything for now, but I’ve got to watch this stock more closely.
I could go on, but I’m sure you get the idea of what you should be doing.
“Know thyself”
The second thing you can do is examine yourself. Are you willing to look at prices and perform the kind of check I’ve just been describing about the strategic layout of your equity investments? Are you able to think about, and perhaps actually make, changes to your portfolio based on data you collect? If so, everything is probably fine.
If not, if, on the other hand, you become really emotional–you refuse to look, or are uncomfortable at the thought of (even temporarily) loss-making investments, then you may have a problem. It could be as simple as having had too much caffeine this morning. Or you may have built more risk into your portfolio than you believe you should have, or are temperamentally suited to have. Or you may have some stocks that, deep down inside, you know you should sell but you can’t seem to pull the trigger. In any event, you may want to start from the ground up examining your strategy. You might also want to read my thoughts on constructing a portfolio.
Portfolio Management–How often to measure(ii), Analyze performance monthly
Most professionals, and many institutional clients, use portfolio attribution reports as a key tool for interpreting the results a portfolio manager achieves. I’ve always found it an excellent planning tool, as well.
I’ve looked on the internet, admittedly not as hard as I probably should have, for a service providing anything remotely resembling a performance attribution report and have found nothing. At some point, I should probably have an attribution tool on this blog, but for now you’ll have to construct a simple one for yourself.
What I describe below is a rough-and-ready tool. It takes shortcuts that simplify the calculations, so the results are not accurate to the last basis point. But for us, that’s not the most important thing. The reason to do create a periodic performance attribution report is to establish a procedure for sitting down and thinking about the actively-managed portion of a portfolio, seeing what is going right and what is going wrong, and deciding what–if anything–to do about it.
For anyone who’s interested, I’ll talk about the major simplifications at the end of the post. Continue reading