How Should Alternative Investments Be Benchmarked?

Following my recent piece on the future of the hedge fund industry, a reader asked:

Interest rates are too low and stock market volatility is too high so we have to hold some alternatives in our client portfolios. Our problem is how do we benchmark these funds? S&P 500? 60/40 portfolio? A hedge fund index?

I’ve heard from a number of investors and advisors over the past few years who have come to the same conclusion — they know they need to take risk but they don’t want to go all the way into stocks and they’re worried bonds aren’t going to pull their weight in a portfolio. Many assume alternatives will shrink in the coming years but in my estimation we’ll continue to see growth in hedge funds, liquid alts and other private investment vehicles because of the market environment (and the scars that remain from the financial crisis).

One of the chief criticisms of the hedge fund industry is the fact that hedge funds as a group have badly lagged the S&P 500 in this latest cycle. They have also underperformed a simple 60/40 almost every single year for the past decade. The problem is that there are various types of hedge funds — credit, distressed debt, event-driven, long/short equities, managed futures, multi-strategy funds, activist, macro, stat-arb, long only, etc.

There’s really no good index or benchmark out there that does a good job of measuring the performance or risk characteristics of all of these types of funds.

A few random thoughts on this topic:

  • The average hedge fund is net long something like 40% in their portfolios. But that doesn’t tell the whole story. They’re not just sitting on 40% in stocks and holding the rest in cash. They could have 150% of their funds long in stocks and 110% short and still be only 40% net long. They’re gross exposure would be 260% through the use of leverage.
  • Volatility figures tend to be based on unaudited monthly performance figures provided by the managers. In most cases the hedge funds themselves are marking to market some of their positions. In most cases I would guess that volatility in hedge funds is vastly under-stated and not necessarily indicative of the actual portfolio fluctuations.
  • Very few hedge fund managers talk about their short books as “hedges.” The vast majority, especially on the fundamental side of the aisle, tend to expect to earn alpha on the stocks they short. If not, why bother shorting in the first place? Cash or bonds can also act as a hedge so by shorting stocks most are really making a directional bet — down (the exception here would be statistical arbitrage funds but even in that space those funds are making relative value “hedges”). Most PMs do their actual hedging by making gross and net exposure changes so it’s more of an asset allocation decision than anything.
  • I would guess that 9 out of every 10 quarterly hedge fund quarterly letters I’ve read over the years makes performance and correlation comparisons to the S&P 500. They may not like that comparison but it’s the one that the majority are doing anyways.
  • Private equity funds are also typically benchmarked against the S&P 500, but these are usually levered up, smaller, distressed companies held in an illiquid fund structure that ties up investor capital for up to 10-15 years. It doesn’t make sense to compare PE funds to the more larger, more mature and more liquid S&P 500 companies.
  • Hedge fund and private equity peer benchmarks are notoriously unreliable. They rely on the funds to self-report, have a huge survivor ship bias and re-state their performance after the fact when new funds report.

So how do you account for the use of leverage in a fund? Or the risk and cost of short-selling? Or the illiquid nature of the fund structures? The lock-ups? The key-person risk? The lack of transparency in the holdings? The fact that many of the holdings are being valued by the funds themselves?

I’m not trying to pick on alternatives here. Investors know exactly what they’re getting themselves into when making these types of investments. I just think that most investors in these funds never bother to consider these risks or even bother to ask themselves, “How should we benchmark our alternative holdings?”

Few ever bother to ask the portfolio managers of the funds, “How do you benchmark your own performance?”

With the potential for an increase in the use of liquid alts in the retail and financial advisor space it’s worth considering a set of questions before investing in these types of funds:

  • How should we benchmark this piece of our portfolio?
  • What risk and returns expectations do we have for this allocation?
  • Are we looking for drawdown protection? Diversification benefits? Uncorrelated assets? A reduction in volatility?
  • How much upside are we willing to forgo for a reduction in volatility?
  • What are the expected returns in this space?

Does it make sense to benchmark hedge funds as a group to the S&P 500 or a 60/40 stock/bond index? Probably not.

Maybe investors in alternatives should benchmark these funds against their own expectations. Why do we hold these funds and are they meeting our expectations? They can compare them to the rest of their portfolio to realize the opportunity cost of holding them. Every investment decision comes down to a simple cost/benefit analysis that too few investors actually go through before making an investment.

Many investors in this space invest first and ask questions later. Or worse yet, they move the goalposts and make up excuses after the fact. The truth is that these fund structures have a unique set of risks and attributes that can be difficult to neatly define in an index or benchmark. It’s up to the investor to figure out if those risks make sense or not in terms of how they fit into their overall portfolio.

Further Reading:
What Hedge Funds Get Right

 

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