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Riskdata study shows factor-based models help investors

Date: Tuesday, May 13, 2008
Author: Riskdata

Research Update: Riskdata study shows factor-based models help investors detect `time bombs` by discriminating between lucky and talented hedge fund managers:

A Riskdata study of hedge fund performance during the recent credit crisis shows that using a non-linear, factor-based model, it would have been possible prior to the crisis to reduce the proportion of hedge fund “time bombs” – those managers who have simply been lucky rather than skilled in their past performance. Using such an approach would have led an investor in a broad hedge fund portfolio to achieve a 4% return over the nine months period ending in March 2008, compared with a 0% return for the hedge fund universe as a whole.

Since summer 2007, a major hedge fund crisis has been triggered by a variety of exploding time bombs – in other words, a massive drawdown on hedge fund managers, who had apparently nothing in their track records prior to June 2007 that could have suggested any potential high risk.

The Riskdata study tackles the question of whether it is possible to detect funds that would not fare well under extreme conditions well in advance of market stress. The study looked at the performance from July 2007 to March 2008 of 3,200 hedge funds and fund of hedge funds, which report returns to HFR Database (Hedge Fund Research, Inc.), and had a track record covering at least the period from December 2004 to January 2008. The benchmark portfolio on which the study is based is iso-weighted on these 3,200 funds. The study broke down the funds into three groups:

Group A – 389 funds (12%) for which the crisis was business as usual; they earned an average return of +8.7% in the period;

Group B – 2,098 funds (65%) that experienced very high drawdowns (an event which would normally occur only once every 8 years using normal distribution standards), but where this was in line with what they experienced prior to the crisis in terms of extreme risk. Investors thus had no reason to be surprised with this performance, given market conditions. The average performance of this group was +1.7%;

Group C – 729 funds (23%) that experienced not only high drawdowns compared to their normal distribution models, but also compared to previous maximum drawdowns (more than twice past drawdowns). In other words, nothing in these funds’ track records could have alerted an investor to a high level of loss. This group, on average, returned a negative –9.4% performance. Unsurprisingly, the highest proportion of “time bomb explosion” have been observed among credit related and relative value strategies (40% of exploded time bombs), while this proportion was much smaller within CTA, short bias and macro funds….

“Delivering 4% of excess return versus an iso-allocated benchmark of over 3,000 hedge funds is an incredible result, the more so as the selection was made at the end of June 07 and kept frozen for the whole nine months test period. The study’s methodology and data are fully transparent, proving that this type of risk management, which recognises the specificities of hedge fund risk through factors, can be used in practice by investors to improve returns….Full further information contact: info@riskdata.com No online Source