The Paradox of Chasing Returns, Part 2
By Kyle Vogel, Head Trader and Senior Analyst of Commerce Asset Management, Sub-Advisor of the AdvisorShares QAM Equity Hedge ETF (NYSE Arca: QEH)
In part one, we looked at the statistics of how difficult it was for hedge fund managers to consistently outperform the universe average. In part two, we wanted to examine the consistency of a hedge fund’s1 performance as its assets grow. We took the HFRI Equity Hedge Fund universe and looked at individual managers’ assets and returns during a recent period. The dataset includes funds reporting at any point between August 2008 to March 2015. With a threshold benchmark of $100 million, we filtered out managers who did not meet the criteria of surpassing the $100 million mark at any point in their track record. We also removed funds that didn’t have at least six months with sub-$100mm returns and post-$100mm returns to remove any insignificant data. Once filtered, we compared the returns vs. the HFRI Equity Hedge Index2 during both relative time periods of pre-$100mm AUM and post-$100mm AUM.
Our results4 mirror the frustrations that allocators have when selecting hedge funds. We found that, before reaching the $100mm threshold, our funds were gaining traction with allocators and gained on average $49mm and returned 13% annualized in excess of the index. We were also not surprised that the funds making this leap in assets had a win rate of 84% against the index. However, after reaching $100mm, the average fund gained $117mm but reverted closer to the mean return.
After all of the background checks, due diligence, screening, and favorable data analyses, manager selection still seems to boil down to a “coin-flip.” The managers took their new wealth and drifted back towards the mean. Perhaps their style became out of favor or the leap in AUM disrupted the chain of decision making. What is certain is that the result is frustrating to the investor. The average starting AUM is quadrupled and most of those investment dollars are receiving average returns if not worse than average. It is akin to a gold rush. The news of a gold strike can lure a vast number of people who will more than likely strike out than strike it rich. Frustrated investors inevitably redeemed capital and moved elsewhere which is evidenced by the average ending AUM being much less than the average peak AUM. What is not calculated is the track record after the fund stopped reporting its performance numbers which leads me to speculate that ending AUM and performance would both be lower if we were allowed to follow these figures longer. It would appear that AUM and past performance are a good gauge of investor sentiment but a poor predictor of future returns.
1 An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group.
2 The HFRI Index is a fund-weighted (equal-weighted) index designed to measure the total returns (net of fees) of the approximately 2,000 hedge funds that comprise the Index. Constituent funds must have either $50 million under management or a track record of greater than 12 months. The HFRI Index consists only of hedge funds. The HFRI Fund universe is one of the HFRI sub strategies.
3 The source for all data used is Commerce Asset Management. All data was used for a hypothetical example.
4 The source for all data used is Commerce Asset Management. All data was used for a hypothetical example.