Is there more to the index than just the average?
Enter: The Restaurant Dilemma
In the final part of our ongoing series, we look at the importance of not making sweeping conclusions based on averages when evaluating hedge fund indices.
As mentioned in our earlier articles on this subject, a quality index can serve as a meaningful benchmark to evaluate manager performance. The index you choose may help determine your overall asset allocation or be the difference between investing in or redeeming from a manager. But when it comes to hedge funds, quality indices have historically been few and far between, leaving allocators with a very limited and often misleading visibility into manager performance.
This is a problem that, frankly, hasn’t seen the amount of attention it deserves. For example, earlier this year, a working paper by a team of respected academics and government economists at the Federal Reserve found that due to incomplete data, the actual size of the hedge fund industry is as much as 40% larger than most common estimates of $3.5-$4.2tn and performance metrics are grossly understated. Complete peer group data is even more important for strategies that deviate from long only equity or fixed income approaches, which is often the case with hedge funds, where an index of peers may be the most meaningful way to evaluate manager performance.
How can an investor determine whether an index is high quality and serves as a meaningful benchmark? We’ve broken down our analysis into four parts, each of which deserves its own level of attention. PivotalPath has developed hedge fund indices that address each of these issues, among many others. Today, we are covering the fourth and final part of our analysis. As a reminder, questions that every allocator should be asking include:
· What are the constituents, or data, that goes into the index?
· What is the methodology used to construct it?
· How is the information presented and is speed valued over accuracy?
· Is there more to the index than the average?
To illustrate the reason why sweeping conclusions should be avoided, think about something we call the restaurant dilemma.
For example, nobody would dispute that New York City offers some of the best restaurants in the world. So, let’s say you were traveling to New York for the first time and decided to use a major restaurant critic to search for the best French restaurant. Would it make sense to average that critic’s ratings across all “French Restaurants in New York City,” and come to an overall conclusion about the quality of New York City French restaurants? If you did so, you may avoid some of the consistently top-rated restaurants in the world based on the conclusion that New York City French restaurants are just, well…average.
While that analysis might sound silly when searching for a restaurant, it is often standard practice when analyzing the hedge fund industry. Further, the broader the index, the more the average may hide what’s happening in the distribution. For example, the mean return for a hedge fund composite index that includes many unique sub-strategies (with uncorrelated or even offsetting performance) would not paint the full picture.
Accordingly, given hedge funds’ ability to execute numerous unique strategies, lumping them into one summary statistic is almost always inadequate. It could generate sweeping conclusions about a fund or even the industry which, by design, would underestimate the value of its parts.
It’s always important to remember that what’s true in the aggregate tells you nothing about the distribution around the mean. An index that reports a return over some time horizon, is merely providing the average of all the fund returns that have been given to them at that point in time. Having the ability to break down performance not only by cohort and quartiles with transparency at the constituent level, can help ensure you evaluate your hedge fund investments in the right context. It may even help you separate the best from the average.
The lack of transparency in hedge fund reporting and the perverse incentives among those who do share their information (i.e., negative selection bias, rush to report, disincentives to revise poor numbers once they have been posted, etc.), create a very distorted view of the actual hedge fund universe. What’s worse, they create the impression that they are complete and accurate, providing a false sense of security for those who use them.
What should allocators do? Ask about what else is provided besides the mean return.
Contact us to learn about what PivotalPath provides in addition to the mean.
Interested the full analysis? It is available on www.pivotalpath.com.