Hedge Fund Analysis

The issue of analyzing hedge funds has become more and more relevant in recent years. Information about hedge funds is often hard to come by and difficult to evaluate. Statistics like downside deviation and kurtosis are interesting, but don’t necessarily get to the heart of what a manager is doing.

The issue of analyzing hedge funds has become more and more relevant in recent years. Information about hedge funds is often hard to come by and difficult to evaluate. Statistics like downside deviation and kurtosis are interesting, but don’t necessarily get to the heart of what a manager is doing. A number of academics have done style analysis on hedge funds to identify systematic risk factors. To do this they have constructed indexes to replicate option prices, credit spreads and other factors. We believe that the hedge fund managers should be evaluated in two steps. First we identify the manager’s style or strategy. Once identified, we can determine the particular risks associated with that strategy. This paper deals with the first step, identifying the style of the fund. We simply want to know, “What does the manager do?” We will show how style analysis works well analyzing both funds with one dominant style and funds with multiple styles, like a fund of hedge funds. We will also drill down in a particular style to get more detail.

Style analysis was developed by Nobel Laureate Bill Sharpe in the late 1980’s. It uses a statistical process (quadratic optimization) to determine a manager’s style by comparing a manager’s monthly or quarterly returns to the returns of selected indexes. For traditional equity managers, style is defined as value or growth, and large, small or medium cap. For a bond manager style might be defined by duration and quality. Hedge fund manager’s style is determined by their strategy, such as convertible arbitrage, long/short equity, distressed debt, merger arbitrage, etc. The indexes selected to do style analysis are critical. A good set of indexes for long only U.S. equity managers are the Russell Large 1000 Value and Growth and the Russell Small 2000 Value and Growth. The indexes used for hedge fund style analysis are the composites created by the various hedge fund data base vendors. These are typically equal weighted composites of hedge manager returns for hedge funds in a particular category or strategy. The standard criticisms of survivorship and selection bias don’t apply here because we are not using these indexes as benchmarks. We are interested only in the return behavior (correlation) of the indexes vs. the manager.

Style Analysis on a Fund of Hedge Funds

We used Zephyr’s StyleADVISOR software to create the hedge fund analysis displayed in Figures 1 through 9. This analysis uses palette of Barclay’s hedge fund indexes selected to represent a broad array of hedge fund styles. For the first example we start with the broadest strategy possible, a fund of hedge funds. Figure 1 shows the combination of indexes that gives the highest correlation to the manager’s returns. In other words, the weights in Figure 1 make up the composite of the indexes whose returns behave the most like the returns of the manager. We call this composite a “style benchmark.” The optimizer tells us that the fund of funds is well-diversified, with the largest portions going to Distressed Securities (36%), Global Macro (17%) and Fixed Income Arbitrage (15%). Because we are familiar with this fund, we know that this is an accurate description of the strategies within the fund. But when looking at funds that we don’t know anything about, how can we be sure that the style benchmark is a good representation of the fund’s style?

Figure 1
Asset Allocation

Testing the Accuracy of Hedge Fund Analysis

In this case we use the style benchmark not to determine the skill of the manager, but rather the accuracy of our style analysis. There are three useful measurements of fit which we can examine in order to evaluate the accuracy of the style analysis—R-Squared, Tracking Error and Beta. Figure 2 tells us that the correlation (R-Squared) between the fund’s returns and the returns of the benchmark is a reasonably high 73.2%. The horizontal axis on Figure 3 shows the Tracking Error. Tracking Error is the standard deviation of excess return (the difference between the manager and benchmark). If the style benchmark does a good job of representing the behavior of the fund, the Tracking Error will be low. Each dot on the graph in Figure 3 represents a three year period, with the dots getting larger over time (the largest dot is the most recent period). In this case the Tracking Error ranges between 2% and 3%. The last measure of fit is the rolling Beta. The blue dots in the graph in Figure 4 represent a rolling 36 month beta to the style benchmark. The beta will give us a clue as to the amount of leverage in a fund. In this case the leverage is not absolute but relative to a peer group average since the indexes we are using represents actual hedge fund returns. These three statistical measures back up what we already knew, that the style benchmark for this fund of funds is accurate.
Figure 2
Performance Attribution
Figure 3
Annualized Excess Return/Standard Deviation
Figure 4
Manager vs. Benchmark: Beta
We have used StyleADVISOR’s flexibility to put all of the information together so that we can see both the style benchmark and the measures of fit on one page, as shown in Figure 5. Next we will use this same page to look at different funds. After that we will add additional pages with different index palettes for more detailed analysis.

Figure 5
Hedge Fund of Funds

Style Analysis on other kinds of Hedge Funds

Hedge fund style analysis is particularly good at identifying a dominant style or strategy. The Merger fund is a mutual fund that does merger arbitrage. Figure 6 displays the results of a style analysis on this fund using the same palette of indexes we used earlier. Here we see over a 90% loading on merger arbitrage and a relatively high 67% R-squared. Figure 7 is an analysis of a hedge fund specializing in convertible arbitrage. Again we have over 90% of the style attributed to convertible arbitrage with a 73% R-squared. StyleADVISOR has done a good job of picking the dominant strategy in these cases.

Figure 6
Merger Fund
Figure 7
Convertible Arbitrage Fund
Figure 8 shows the style analysis of an emerging market fund where there is a 100% loading on the Barclays Emerging Markets composite. This is a clear result, but leaves you wanting to know more. Figure 9 uses a set of regional emerging market indexes (Asia, Eastern Europe, and Latin America), allowing us to see regional exposure. This emerging market hedge fund seems to be almost equally split between these three regions.

Figure 8
EM Fund
Figure 9
EM Fund

Hedge Fund Style Analysis Generates Insightful Questions

Style analysis can give us an idea of what a hedge fund manager has done and generally how consistent they have stuck to a particular strategy, but don’t expect this analysis to be precise. One of the most powerful uses of hedge fund style analysis is the creation of insightful questions. These are questions that you can ask the manager that will help create a dialogue. Figure 6, for example, shows that in the early period from January 1997 through about June 2002 the fund was 100% merger arbitrage. From 2002 until the present we see an increasing amount of “Equity Long Bias”. At about the same time this started, the tracking error jumped from around 2.2% to over 4%. Also, at the same time the beta increased from around 1.10% to over 1.5%. The increased beta suggests an increase in leverage. But the higher exposure to unhedged equities in the style analysis suggests that at least a portion of the fund has been unhedged. These would be questions to ask the portfolio manager. The answers may be those we have suggested or something else entirely.

Style analysis on hedge funds is a useful and interesting tool that can get to the heart of what a hedge fund manager is doing and how the hedge fund is behaving. It identifies the style, or strategy of the manager, and can be used with more specific indices to get further detail on that strategy. It can also be used to raise meaningful questions, helping investors have more productive dialogue with managers.

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