Beating the average
Hedge fund stars make their clients pots of money, right? If only hedge fund investing was so simple. The truth is that managers with stellar reputations can have poor-performing investors. And the real stars are those who do well on metrics that the industry tends not to disclose.
Most investors look for a track record of decent annual investment gains when choosing a hedge fund manager. Take Greg Coffey, who recently retired from Moore Capital Management. On the industry’s conventional measure, he was a successful trader: annual returns of 22 percent per annum on average from 2004 to 2012, helped in no small part by gains of 60 percent in 2006.
But the 22 percent figure, while impressive, doesn’t tell the full story about how much money Coffey made for investors. Clients who bought into Coffey’s GLG Emerging Markets fund at launch in November 2005 would have trebled their money by 2007, and would still have been 100 percent up at the end of 2008, the year when the fund fell 35 percent (Coffey resigned in April). But what about investors who bought in the second half of 2007, just before the fund peaked in February 2008? Quite a few of them probably earned a lot less than 22 percent.
Dollar-weighted returns vs average returns
To know what the average investor made from a hedge fund manager requires looking at a number that is rarely published – the so-called “dollar-weighted return”. This is the hedge-fund equivalent of the internal rate of return (IRR). In technical terms, it is the discount rate that reconciles the present value of everything paid into a fund with all its outflows. It measures what the fund manager achieved with all the money he received, adjusting for the time investments were made and redeemed.
Dollar-weighted returns are typically lower than annualised average returns, for both hedge funds and other asset managers. The most comprehensive research, an analysis of 11,000 hedge funds by Harvard Business School and Emory University’s Goizueta Business School, shows a difference of at least three percentage points between average annual returns and dollar-weighted returns.
The variation between dollar-weighted and average annual performance could be much more pronounced though. Imagine a hedge fund manager who starts out with a good reputation from an investment bank proprietary trading desk. He attracts $200 million in the first two years of his fund, delivering annual returns of 20 percent. This strong track record has investors knocking on his door, allowing him to raise $400 million in the third and $1 billion in the fourth year. But with a bigger fund he finds it harder to achieve the gains he used to. He takes bigger risks, applies more leverage, and suffers a minus 10 percent year, just after he has raised lots of new money. Investors, panicking, pull their money out.
In this hypothetical example, the bad year brings down his average annual returns a bit. The compound annual return for the four years is about 12 percent. But in reality, many of the manager’s investors piled in before his worst year and lost money. The dollar-weighted return would be a measly 3 percent, and with a 20 percent fall in the last year would have been negative. Yet the manager earned good fees off the few, while not sharing much in the financial losses of the many.
Better disclosure needed
Critics of using dollar-weighted returns argue that they show little about a manager’s trading ability, since they are heavily influenced by investor timing – particularly the tendency to pile in right after a fund performs strongly – which is beyond the manager’s control. And it would not be fair to judge a manager’s ability purely on his or her dollar-weighted return.
Still, these numbers are worth paying attention to, even if getting them isn’t easy. Low or falling dollar-weighted returns may be a signal that a firm is growing assets quicker than its traders can find good investments, or flogging a strategy after it is already exhausted.
Dollar-weighted returns also give a powerful indication of the hedge fund industry’s past failings, and the value destruction of the asset-gathering boom and bust that ended in 2008. Average annualised returns since 1980 for the funds tracked in the Harvard and Emory research were 12.6 percent, taking into account 2008. Dollar-weighted returns were just 6 percent, very close to the average interest rate on risk-free Treasury bills over the same period.
Many managers have done well for their investors. The top 10 have generated $185 billion net of fees, says LCH Investments. But high performance fees can make managers fantastically wealthy, even if subsequent losses mean the average investor in their funds may not have made much. Investors should know their IRRs from their elbows.