FoHF unveils new hedge fund ranking system

Date: Friday, June 11, 2010
Author: Hedge Funds Review

Fund of hedge fund manager Lyster Watson has developed a hedge fund rating and ranking system it claims provides a better indication of a manager’s skill than traditional measures such as Sharpe and Sortino ratios.

Lyster Watson and its managing director Marc Freed were granted US patent protection on the True Alpha ranking methodology in April 2010.

Lyster Watson developed the True Alpha methodology as an alternative to the Sharpe and Sortino ratios, "which are useful tools but have some shortcomings when used as a measure of hedge fund manager skill," said Robert Watson, founder and chief investment officer of Lyster Watson.

"There are a number of factors that contribute to the returns of a hedge fund, from market beta through to the risk the manager takes on in the form of leverage or shorts. As an investor, we wanted to understand how those returns were achieved," explained Watson.

"The Sharpe and Sortino ratios do not factor in all the potential contributors to a hedge funds return, most obviously leverage," added Watson.

Traditional performance ratios measure excess return by comparing the performance of an investment to a risk-free or target rate relative to its volatility or downside risk.

The True Alpha system rates hedge funds by comparing their returns and volatility to a benchmark comprised of its peer group.

To determine the benchmark, Lyster Watson creates a portfolio of funds and then uses a Monte Carlo technique to calculate its performance within a 95% confidence level. This approach allows Lyster Watson to control the sample and remove outliers from the benchmark where appropriate.

The strategy benchmark incorporates the risk free rate and the market and strategy beta, "so we are able to see how much of the fund's return is attributable to the strategy beta, how much is risk free, how much is due to leverage, and finally, how much is down to the manager's skill," said Watson.

The True Alpha system differs from the Sharpe and Sortino ratios in that "it does not give any credit for leverage" and has a more equal weighting towards risk and return, whereas "the Sharpe ratio provides a higher reward for risk reduction," said Watson.

The True Alpha system has proven to be "an extremely useful tool" for screening managers for inclusion in Lyster Watson's funds of hedge funds, said Watson.

Lyster Watson has also used the True Alpha methodology to create a selection of more than 20 hedge fund indexes across various strategies and geographies. The indexes form the basis for the True Alpha Trend Trackers, a set of investable strategies that track the strategy-level performance of hedge funds. The Trend Trackers replicate the performance of these strategies using liquid instruments such as ETFs, listed futures contracts, government bonds, and money market assets.

Because the strategy benchmarks are built from the bottom-up using strategy-specific portfolios of hedge funds, the True Alpha Trend Trackers are less volatile than composite indices and more closely resemble the performance of hedge fund portfolios, said Watson.

"These strategies offer investors exposure to hedge funds returns with greatly improved liquidity and transparency. We think they will be attractive to a wide spectrum of investors," said Watson.