Investment funds exist for one reason and one reason only. To exploit perceived price inefficiencies in any market and generate alpha for investors. Occasionally, exceptionally good performance is rewarded with attention from the media, the wider financial community and most crucially, potential investors. Usually, performance follows an “alpha production curve” that starts with returning alpha at inception but then shows a decline as time progresses and size increases. Over time, as inflows increase and the fund’s strategy reaches capacity, its ability to create alpha dissipates. The question that then persists is - can investors determine the “Golden Hour” of a hedge fund and when is it time to place that redemption notice?
The chart below is a good example of how a fund has been outperforming the benchmark in the first 2 years after launch, which was then followed by a 1 year of clear underperformance, measured by the 12-month rolling annualized outperformance of its benchmark. The pattern then repeats itself clearly indicating that the fund was having stretched periods of great outperformance but also larger periods of underperformance when compared to its benchmark.
Source: Fundbase, as at 30.04.2021
At a granular level, the analysis shows that managers experience inconsistent periods of alpha performance and that over time, the annualized excess return compared to the benchmark suggests alpha production is diminishing.
Performance fluctuates in conjunction with many factors, some of which are triggered by a changing regulatory environment or operational framework, to execute a particular strategy. Very often, an increase in AUM can also drag on a fund manager’s ability to perform. As performance fluctuates, investors must discern whether the current result is a function of the current market environment and whether to stay invested, or to place a redemption notice.
Performance issues at the fund level can be either cyclical or structural. Cyclical issues arise due to seasonality effects of a fund’s strategy or the natural ebb and flow of investment styles that are working in today’s market. Structural concerns consist of ‘operational’ issues, both traditional and non-traditional. Investors should be highly skeptical of structural concerns and be ready to redeem shares if a plan to improve on any structural concerns is inadequate or non-existent.
Traditional issues could be breaching stated investment guidelines, changing key personnel, ethical concerns, and increasing counterparty risk. Non-traditional issues are observed systematically through intelligent quantitative tools and consist of analyzing a fund’s performance through a variety of focal points: alpha production capacity, beta risk, performance persistency and risk mitigation.
Through a comprehensive quantitative approach of non-traditional metrics and algorithms, portfolio returns can increase through actively monitoring managers with “Golden Hour” characteristics and changes in alpha capability. Using a walk-forward methodology and incorporating fund liquidity constraints such as lock-up periods and redemption fees into the algorithm, research shows the average 12-month performance of funds in their “Golden Hour” is six percent higher than funds exhibiting deteriorating alpha capacity – indicating the end of the “Golden Hour”.
Maintaining a longer-term perspective for investments in hedge funds is paramount, as entering and exiting investments is not only costly but also a time-consuming process, especially if there are significant liquidity constraints in place. Since the lag time between deciding to redeem and receiving funds can be substantial, there is a strong potential for missed opportunity. Therefore investors should be careful and focus on identifying material changes in opportunity sets through traditional and non-traditional performance measures, as well as the fund manager’s commitment to execute the presented strategy.
Every investment has to deal with performance cycles and hedge funds are no exception; however, some hedge funds might never recover. With the use of quantitative tools and an intelligent analysis process, investors can identify the difference between temporary cyclical changes and permanent structural changes. For temporary changes, stay the course. When the winds shift and issues become structural, it’s time to consider new opportunities.
If you are a professional investor looking for alternative funds that meet your unique investment objectives, visit www.fundbase.com or contact a member of our team.
Investment Analyst, ACOLIN Fundbase