Shame on the Sham
By Ron Surz

On July 6, 2005, a commentary was posted to Albourne Village, a Web site for hedge fund professionals, by Dr. John S. Wisnioski, a hedge fund veteran and principal of Gan Consulting Ltd. Dr. Wisnioski stated:

"The following describes my experience with three multi-billion dollar hedge funds-of-funds and their due diligence and allocation processes … The big funds-of-funds have such constant and substantial inflows each month that their need is to find valid counterparties and then put their capital to work. The fund-of-funds business, again in my humble view, is becoming more like a 'commodity' investment business where the scale is so great that protracted due diligence is not the most important order of the day. Capacity, decent manager performance, marketing the fund-of-funds product and keeping the whole thing under control are the pressing exigencies.
… We are not advocating avoidance of such manager due diligence, but rather, we are attempting to shed light on what really happens in practice during the investment process for many of the more established funds and funds-of-funds, in contrast to emerging or start-up managers."

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 an average manager. The challenge with hedge fund investing, for both individual investors and fund-of-funds, is identifying managers who have skill; in other words, identifying managers who are above average.

Long-short investing can be superior to long-only investing, but not if it is provided by an average manager. The search for skillful managers is a difficult task that is complicated by the use of performance evaluation tools that suffer from documented deficiencies. 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 and/or index, but this simply does not work for hedge funds. It is time to recognize the deficiencies of these popular approaches so we can open up consideration to new contemporary methodologies.

Marketing compensates for mediocrity in the money management game, at the expense of the client. In the following, we describe the problems with using peer groups and indexes to evaluate hedge funds, and offer up a solution.

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 basic problems with peer groups: They are loaded with biases. But biases are not the only-or even the biggest-problem with hedge fund peer groups. The biggest problem is that hedge funds are unique. Dr. Harry M. Kat (2003) documents the lack of correlation among funds in the same peer group. For example, Kat finds correlations to be a mere 0.23 among funds in market-neutral peer groups, substantiating the fact that these funds are different from one another and therefore should not be compared to one another. Accordingly, it is virtually impossible to construct an appropriate peer group for a specific market-neutral manager. Kat also finds low correlations across hedge fund indexes for the same strategy, thereby establishing the unreliability of hedge fund indexes, which, of course, are based on faulty peer groups. Hedge fund indexes are discussed in the next section.

Malkiel and Saha (2005) 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 they failed to properly diagnose this disease as not only a myriad of biases but also, and most importantly, the uniqueness of hedge funds.

The Problems With Hedge Fund Indexes

Indexes serve three major purposes:

• Benchmarks for evaluating investment manager performance.
• Templates for passive investment portfolios.
• Barometers of growth in different segments of the market.

Hedge fund indexes are generally being used for all three purposes, but really should be used only as a barometer of industry and strategy performance. Even then, the user should be very cautious. The problems with using hedge fund indexes in traditional indexing roles are as follows:

• Benchmarks: As described in the previous section, hedge funds within a peer group are not well-correlated to one another. Hedge fund indexes are amalgams of hedge fund peer groups. Accordingly, an individual manager will win or lose to a hedge fund index primarily because of allocation differences, rather than skill. In addition, Kat (2003) has documented dissimilarities among the various indexes, complicating the choice of index. For example, there are material differences between "investable" indexes (i.e., those used as templates for investable products) and generalized indexes.
• Portfolios: Passive investment portfolios are designed to capture the natural return, or essence, of a market, eliminating any potential for value added or subtracted by skill or lack thereof. But skill is the essence of hedge fund investing; eliminate that and you are left with mediocrity at best, which is what hedge fund investors are trying to get away from in the first place. "Investable" indexes are not passive products in this usual sense of the word, but are instead funds of funds constructed by committee for the purpose of diversification. Here again there is potential to diversify away the benefit, namely skill. Replicating techniques suffer from the same problem: Replication captures beta, not alpha.
• Barometers: Hedge fund indexes do work as barometers of strategy and industry performance, because they measure the performances of broadly diversified portfolios of these strategies. In other words, managers should not be evaluated against indexes, but inferences may be drawn from indexes regarding a general sense of the success or failure of individual strategies. For example, one might infer that global macro strategies as a group have generally performed well, while distressed debt has not. But one needs to be careful because the various hedge fund indexes behave quite differently, so an inference drawn from one index might not be supported by a comparable index from another provider.

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