13 Aug 2012 - Performance is Reality

Our CEO, Chris Gosselin, wrote this article last week for the EurekaReport.

When evaluating managed funds, "only performance is reality".

We see all sorts of claims regarding fund performances - both from the managers themselves, in some sections of the media, and in so called "independent" research reports - which try to suggest that a fund is performing well, or has gained a recommended or highly recommended rating in spite of the fact that they have lost investors' money.

There's an appropriate quote from the former head of ITT, Harold Geneen as follows: "words are words, and promises are promises, but only performance is reality".

With apologies to Mr. Geneen, but when it comes to managed funds, and hedge funds are no exception, "performance is the only reality".

In our opinion, neither a rating, a recommendation, nor the soothing words and promises in a fund's marketing material means anything if that fund has failed to perform.  Of course performance means different things to different people (as we've seen recently at the Olympics) but in the field of absolute return and hedge funds it is fair to say that investors should expect a positive return. 

According to the www.fundmonitors.com  database of absolute return and hedge funds, 43% of funds provided a positive 12 month performance to June 2012.  Although 80% of funds in the database outperformed the ASX200 it still leaves 37% of funds outperforming the ASX but failing to provide their investors with a positive return.   Well tried perhaps, but we suspect neither the fund manager nor their investors would be overly happy, and we doubt that Harold Geneen would have been impressed.

What he would have been impressed with however would have been those that provided a positive performance including the following list of the top 10 equity long/short hedge funds over 12 months to June, 2012:

An impressive list, and in these difficult times such performances were difficult to achieve to say the least.  However, as readers would understand, 12 months is not long enough to really gauge a fund manager's performance, and further examination reveals some telling trends.

In recent articles we have shown that various funds and strategies can produce significantly different performances in different market conditions.  What is interesting about the performance of funds in the 12 months to June 2012 is that those with a positive performance over the last 12 months also showed a capacity to perform over the longer term.

It is also fair to say that the strategies that performed in the volatile conditions of the past 12 months tended to be risk averse with low net market exposure, rather than the high conviction, concentrated portfolios that had provided often spectacular performance in previous years, but often with high volatility.

This suggests that the past 12 months have been tough, an opinion which is unlikely to have many readers disagreeing with.  But it also suggests that those funds able to navigate the tough markets of the past 12 months have the necessary skills and capacity to do so over the longer term. 

And some definite trends emerged, further consolidating the benefit of avoiding risk when seeking consistently positive returns over the longer term.

Further investigation showed however that performance over the past 12 months was as good a method as any of filtering risk averse managers and funds.  Only four funds with a positive 12 month performance failed to provide a positive 24 months, and of the remaining, only four fell at the three year hurdle.  Four years became a little harder, with six falling by the wayside, and over five years, a few more.

Finally 26 funds (across all strategies, investing in both equity and non equity type assets) with positive returns over one year also had positive annualised returns over past two, three, four and five years.

That would appear to be enough to really sort the wheat from the chaff, but even within this group of 26 there were some performance measures which still required refining, most notably the intra year drawdowns in 2008 at the height of the GFC.   With the market down over 50% from its peak in November 2007 we removed any fund with a drawdown of 20% or more, leaving just 17 funds remaining.

Finally we measured each fund's risk adjusted performance as measured by the Sharpe Ratio, arrived at by taking actual returns less the "risk free" cash rate, divided by volatility.  Ideally this should produce a number as close to one as possible, but we took the top ten to produce our list of "best funds".

No doubt there will be arguments from some that this methodology is imperfect, and we readily admit that there more ways than this to filter good funds from bad.  For instance, some investors may not be so concerned about volatility, preferring to just take a fund's long term annualised return as the true measure of performance, and of course what suits one investor's risk and return appetite may not suit another's.

The list below also excludes some newer managers who don't have a five year track record, but somewhere along the way a line has to be drawn.  If good enough they'll no doubt appear in these columns next year, or the year after. 

So stripping away the words and promises of the marketers, here are 12 funds which have provided positive returns over five years to June 2012, while having a drawdown of no more than 15% during that time.    Performances over 24 to 60 months are annualised:  Sorted alphabetically.

By any standard this is an impressive performance from each of the above funds, but to have provided investors with positive returns each year over five years during some of the most difficult and turbulent market conditions is a significant achievement.  The fact that they are all "hedge funds" should dispel the myth that they are risky and speculative, and in fact reinforces one of the common factors amongst all the funds on the list:  First and foremost they consider the risk of loss of capital as more important, or at least equally important as providing a positive return.

Remember, "only performance is reality".

Chris Gosselin