Tuesday, January 24, 2012

Calculating Investment Returns

The calculation of returns from any asset class - stocks, bonds, funds, etc. - is on the surface a straight forward proposition.

The problem is the most conventional calculations don't take into account a number of other factors, including survivor bias, the timing of cash flows, or performance fees.

I was reminded of this challenge the other day when I was attending a presentation discussing the merits of hedge funds as part of an overall investment strategy.

The presenters were making the case that as a whole the returns for hedge funds investors have largely been superior to conventional "long only" investments in the market.

Moreover, according to their calculations, the returns have been achieved with less volatility, so the case for hedge funds should be self-evident.

However, as numerous commentators have pointed out, its not that simple.

Although there is nearly $1.9 trillion invested in hedge funds at the present time, the community is far from being homogenous. There are numerous different types of funds, for example, ranging from so-called macro funds (which bet on the direct of global markets) to relative value arbitrage (trying to gain based on price differences between related securities).

Then there is the problem of survivor bias.

Most funds start out relatively small, build a track record, and then grow as investors flock to the most successful hedge fund operators.

However, numerous funds start out, and then fail, as the results either do not attract new investor dollars or returns are not sufficient to earn performance fees.

Yesterday's Financial Times had a short piece about the disappointing returns for many in the hedge fund community, and what it has meant for compensation:

More than two-thirds of hedge funds are below their high-water marks, the point at which they are able to charge investors performance fees, according to Credit Suisse.

The main source of income for hedge fund managers is their share of investment profits, typically 20 per cent; but if a fund drops in value, the manager must recoup past profits before charging any more performance fees...

...Just over a third of event funds, which seek to trade around corporate activity such as mergers, or long-short equity funds that pick stocks, are at least 10 per cent below their high-water marks.


And what about the timing of cash flows?

An obvious example of this is famed hedge fund manager John Paulson, who made more than $5 billion betting on the collapse of the US housing market. Paulson's incredible track record was compiled while his funds under management were relatively modest by hedge funds standards.  However, once word spread of his midas touch, Paulson attracted huge amounts of assets.  But then last year, after several ill-timed bets on bank stocks, Paulson's investors lost 40% of their funds.

So the question becomes:  What were the returns for Paulson's investors?

Author Simon Lack writing in his new book Hedge Fund Mirage:  The Illusion of  Big Money andWhy It's Too Good to be True walks through the math of why returns for most hedge fund inveors have not been as attractive as advertised.

Say an investor places $1 million with a hedge fund at the beginning of the year.  The fund has a terrific year, gaining +50% for the next 12 months, meaning the closing account value is $1.5 million.  Net profit to the investor:  $500,000.

Terrrific! says the investor.  Let's add another $1 million to our investment, since the fund is clearly a winner. The investor now has a total of $2.5 million invested in the hedge fund.

Unfortunately, the next year turns out to be a disaster - the fund is down -40%.

The investor's $2.5 million is now worth $1.5 million.  Since he had put a total of $2 million with the hedge fund, the loss of $500,000 means that his investment return is now -25%.

However, under conventional reporting standards, the hedge fund will report an average annual return over two years of +5% (+50% for year 1 and -40% for year 2).  While this is mathematically correct, the actual investment experience has been considerably more disappointing than reported.

While Lack is specifically targeting the hedge fund community in his example, I think you could also make the same mathematical argument for any investment. For example, Fidelity's Magellan Fund produced terrific returns for its investors in the early years, when it was relatively small, but only index-like returns when it grew to nearly $100 billion in size.

I haven't even begun to discuss the whole question of hedge fund fees - which are generous, by any standards - but the whole issue makes me wishing there was a better way to figure out investment results.