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Evaluating Future Hedge Fund Returns: Beyond the Numbers

Driving Future Hedge Fund Returns, Performance

With so many articles about “hedge fund performance” popping up recently, investors are right to wonder what is driving this increase in returns and renewed investor interest. With thousands of funds spread across multiple strategies and differing levels of performance, it is critically important to understand drivers of performance and the corresponding outlook for future hedge fund returns.

Investors may know that during the varying economic conditions of the prior decade, hedge funds generated strong performance in an upward trending market while truncating risk to investors when markets fall. But what else should investors know about hedge fund performance before investing?

Evaluating Market Environment for Future Hedge Fund Returns

The market environment is more significant than market direction in developing an expectation of future hedge fund returns. At a basic level, the majority of hedge fund strategies are “short correlation and long dispersion”. This means that a market with declining correlations (i.e. securities are not all moving in the same direction) and rising dispersion (i.e. wider gaps between top and bottom performing securities) within and across asset classes is the ideal investment climate for most hedged strategies.

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While recent years have been dominated by Central Bank policies and various forms of quantitative easing, correlations became extremely high. At the same time, the outcome dispersion for stocks, bonds and other types of securities was extraordinarily low. This meant that within classes, assets were generally all moving in the same direction. And, there was little variation between individual performance.

While recent years have been dominated by Central Bank policies and various forms of quantitative easing, correlations became extremely high.

However, most recently, we have seen a paradigm shift towards lower correlations and rising dispersion. We have now seen a nearly two-year period of rising interest rates, first in the U.S. and more recently across the globe. This has coincided with a decline in cross-asset correlations and an uptick in hedge fund performance. Against the backdrop of “expensive” stocks and bonds, this differentiated hedge fund performance serves an increasingly significant role within a diversified portfolio.

Understanding Specific Hedge Fund Strategies

In addition to assessing market conditions, investors should understand the primary sources of return in different hedge fund strategies and their underlying investments. These return drivers can be analyzed qualitatively, statistically and operationally.

From a qualitative perspective, investors should understand the specific investments held by a hedge fund manager. They should look at the construction of the overall portfolio, including:

  • The dollar amount and number of shares of certain holdings
  • Which regions and sectors are favored
  • The stylistic composition of the fund
  • The liquidity, concentration, leverage and complexity of the overall investment strategy

Statistically, beyond an assessment of historical returns, investors should feel comfortable with the risk-adjusted performance profile of a fund in relation to their investment goals. This could include an analysis of:

  1. Performance of the fund based on historical volatility in markets
  2. The potential for declines in fund performance if market conditions change
  3. The drawdown potential, or the possibility of losses, down from a performance peak.

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Other considerations could include:

  • The correlations with other holdings within an investor’s portfolio (uncorrelated assets create diversification in a portfolio)
  • Market beta (a fund’s dependency on broader markets as a core driver of performance): The contribution to returns from alpha, or manager-specific performance, above and beyond a relevant benchmark

Lastly, investors should also assess the operational capabilities of each firm regarding:

  • Internal policies and procedures
  • Pricing and valuation methodologies
  • Connection with top-tier service providers
  • Commitment to institutional best practices in managing not only an investment fund but an overall business.

Too often, investors rely upon historical performance and extrapolate future hedge fund returns to make an investment decision. Drilling into the sources of return, the statistical robustness of the performance and the strength of each firm’s operational business processes is as important. In fact, it is likely more predictive in assessing the future impact of each investment within a diversified portfolio.

About Joe Burns

Joseph Burns is Managing Director and Head of Hedge Fund Origination & Due Diligence at iCapital Network, where he is responsible for leading the single-manager analysis and developing multi-fund solutions for clients. Prior to joining iCapital, Joe was a Partner and Co-Chief Investment Officer at Pulse Capital Partners, responsible for manager sourcing, diligence, establishing portfolio…

Read Full Bio »   •   View all articles by Joe »

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