Print this article

The Mystery of Mediocrity

Ron Surz

PPCA Inc

5 July 2006

Presidio Wealth Management of San Francisco recently released a white paper entitled “Demystifying Hedge Funds II” (WealthBriefing June 12) in which the authors describe the failure of hedge funds to perform better than plain old traditional investments. The paper recommends heightened due diligence to separate the wheat from the chaff. With high fees and high investor interest, many marginal players have entered the hedge fund management game, and some marquee funds have become too bloated to add value. But despite the authors’ admonitions, due diligence is not likely to improve. This is the mystery of hedge fund due diligence: Why do intermediaries insist on clinging to old ways that are well known to lead to mediocrity at best? Due diligence can be distilled down to two crucial questions: (1) Do we like the strategy that this manager employs? (2) Does this manager execute the strategy well? Common hedge fund due diligence, as it is practiced today, answers the first question with hot performance, and accepts conceit and concealment as answers to the second. This is a shame because investors have relied upon and paid for skill, but have instead been shammed by fake due diligence. Skill is the only glue that can hold together the promise of low risk with the expectation of good returns. No one wants a below average doctor. In the hedge fund industry there’s nothing worse than mediocrity. An integral part of a true due diligence process is getting the numbers to tell their most important stories, confirming subjective judgments about the talent of the people and the wisdom of their processes and philosophy. This story is virtually always told by contrasting a manager’s investment return to a peer group, but this simply does not work for hedge funds. We call this misguided practice “the mystery of mediocrity”. It’s time to recognise the deficiencies of this popular but antiquated approach so we can open up consideration to new contemporary methodologies. In the following we describe the problems with hedge fund peer groups, and offer a solution. Mediocrity need not be the norm. The Problems with Peer Groups Peer groups are unreliable backdrops for evaluating hedge fund performance. Everyone who has earned the CFA (Chartered Financial Analyst) designation has learned the problems with peer groups: they are loaded with biases. But biases are not the major problem with hedge fund peer groups. The fact that hedge funds are unique is the big problem. Dr Harry M. Kat created a stir with their criticisms of hedge fund peer groups, and the hedge fund industry responded with their own criticisms of Malkiel and Saha’s lack of understanding of the industry. Both are right. Malkiel and Saha identified some symptoms of the disease but failed to properly diagnose this disease as not only myriad biases but also, and most importantly, the uniqueness of hedge funds. A Better Way The solution to the problems with peer groups is actually quite simple, at least in concept. Performance evaluation ought to be viewed as a hypothesis test where the validity of the hypothesis “performance is good” is assessed. To accept or reject this hypothesis, construct all of the possible outcomes and see where the actual performance result falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not good. In other words, the hypothesis test compares what actually happened to what could have happened. This is accomplished through the use of Monte Carlo simulations (MCS) that generate all of the possible implementations of the hedge fund manager’s strategy. For a detailed description of MCS, see Surz . Monte Carlo simulations are well-known to the alternative investments community. Randomly generated outcomes provide a backdrop for decision making by revealing what could happen under uncertainty. The application of Monte Carlo simulations has been extended to the evaluation of hedge fund performance. The simulator randomly creates thousands of portfolios that conform to the same portfolio construction parameters followed by the actual hedge fund manager. Returns-based analyses can be helpful to identifying these construction parameters. Note also that holdings transparency is not required. In a poetic sense the manager is hoisted upon his own petard. Hedge fund manager due diligence should not employ peer group and index comparisons because peer groups have documented deficiencies, and hedge fund indices are constructed from these faulty peer groups. Fair and accurate yardsticks are provided by a contemporary application of hypothesis testing that uses Monte Carlo simulations to create a background of all possible portfolios. It’s time for hedge fund investors to get what they pay for, or they will stop paying. REFERENCES Kat, Harry M. “10 Things That Investors Should Know About Hedge Funds.” The Journal of Wealth Management, Vol 5, No. 4, Spring 2003, pp 72-81. Malkiel, Burton M. and Saha, Atanu. “Hedge Funds: Risk and Return.” Financial Analysts Journal, Vol 61, Num 6, 2005 Surz, Ronald. “A Fresh Look at Investment Performance Evaluation: Unifying Best Practices to Improve Timeliness and Reliability.” Scheduled for publication in the Journal of Portfolio Management, Summer 2006. “Testing The Hypothesis ‘Hedge Fund Performance is Good’.” The Journal of Wealth Management, Vol. 7, No. 4, Spring 2005, pp 78-83. Ron Surz is president of PPCA Inc and principal of RCG Capital Partners LLP He can be contacted at ron@ppca-inc.com or 949/488-8339