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“It sounds counter intuitive but there are good risk takers and bad risk takers” |
The study looked at the performance from July 2007 to March 2008 of 3,200 hedge funds and funds of hedge funds that had a track record since December 2004.
Investors typically select a fund based on previous returns. This means avoiding funds that have had abnormal return distributions and large drawdowns. Although this method eliminates extreme risk takers from a portfolio, it fails to detect “time bombs with hidden risk” says Riskdata’s chief executive, Olivier Le Marois. Indeed, selecting funds based on this method would have resulted in returns of just 0.4% for the July to March period.
Funds that experienced high drawdowns in their lifetime before the credit crunch and market turmoil that began last July actually performed better in the testing market.
“Staying away from managers that have had monthly drawdowns in the past results in forming a concentrated portfolio of funds with quiet returns and a good track record,” says Le Marois. Although an investor might think that this is a safe bet, in fact many of these managers have been running strategies that relied on low volatility, and before July had not been tested as risk takers. “It sounds counter intuitive but there are good risk takers and bad risk takers. When investors saw in June that the markets were going to be difficult, they would have been better off looking for managers that had dealt with risk exposure in the past, had drawdowns and continued to perform – a good risk taker in other words.” Almost 2,100 of the 3,200 funds studied experienced heavy drawdowns in the July to March period but these drawdowns were in line with those experienced before the crisis. The average performance of these funds was 1.7%. “Investors who had selected these funds would have no reason to be surprised by drawdowns during the credit crunch as they were no different to drawdowns in the previous market environment.”
The so-called “time-bombs” that should have been avoided, says Le Marois, were those funds with track records that did not have significant drawdowns in the past. “In other words, nothing in these funds’ track records could have alerted an investor to the high level of loss.” Of those hedge funds studied, 23% had extremely high drawdowns over the July to March period, yet did not have track records that would have indicated this. This group of funds returned on average –9.4% over the period examined. Essentially, these funds had perhaps just been lucky in the past. The majority of these funds were running credit-related and relative-value strategies. “Credit spreads were low vol between 2003 and 2007, so anyone exposed would have a low vol and a good track record, which sounds good,” says Le Marois. “But the market environment created that, not necessarily them. If investors looked at a fund that had had drawdowns in a shaky credit environment before, they might have decided against investing but rather these are the funds that managed risk successfully, had a drawdown but then came through.”
Factor-based modelling that models the relationship between market factors and manager returns would have better alerted investors to funds that would lose money, says Le Marois. “If the industry is to continue to attract and retain institutional money, parts of the industry needs to take the opportunity to rethink their approach to risk management, which can be turned into profit when appropriately implemented.”
