How To Capture A Manager’s “Golden Hour”

Investment professionals, managers, and traders launch hedge funds to exploit perceived price inefficiencies in any market. Good managers launch and achieve exceptional performance figures. The performance attracts attention from the media, financial professionals, and other investors. Investors then subscribe, sending money to the fund. Over time, the fund’s alpha capability dissipates for a variety of reasons, and when this happens, it’s no longer the most efficient allocation of capital. How can investors determine when the “Golden Hour” ends and it’s time to place a redemption notice?

Traditionally, managers follow an “alpha production curve” that starts with returning alpha and shows a decline as time progresses and size increases. Typically, managers excess return profiles look like the following chart over time. At fund inception, managers have a great idea and typically the right time for a strategy. Over time, the manager ability deteriorates to a point where alpha is no longer produced and it’s time to seek new opportunities.

Article3_1Source: Fundbase

The above chart might be exaggerated, but this phenomenon is prevalent in funds that look like excellent investment options to a casual observer. The following fund is a real example of a fund with deteriorating alpha capabilities. This fund (below) achieved returns in excess of 13 percent since inception and consistently outperformed relative benchmarks.

Article3_2Source: Fundbase

Diving deeper, the analysis shows managers experience inconsistent periods of alpha performance. Over time, annualized excess return compared to benchmarks suggests alpha production is diminishing. Performance fluctuates in conjunction with other factors such as assets under management (AUM) and alpha capability. In many cases, an increase in AUM can drag on a manager’s ability to perform. As performance fluctuates, investors must discern whether the current result is a function of the current market environment and to stay invested or to place a redemption notice.

Article3_3Source: Fundbase

Maintaining a longer-term perspective for hedge funds is paramount. Entering and exiting funds can be a time-consuming process, especially if there are significant liquidity constraints in place. Since the lag time between deciding to redeem and receiving funds can be substantial, there is a strong potential for missed opportunity. As a result, timing managers should be less about hopping around, getting into what’s hot today and more about identifying material changes in opportunity sets through traditional and non-traditional performance measures.

Performance issues at the fund level can be either cyclical or structural. Cyclical issues arise due to seasonality effects of a fund’s strategy or the natural ebb and flow of investment styles that are working in today’s market. Structural concerns consist of ‘operational’ issues, both traditional and nontraditional. Investors should be highly skeptical of structural concerns and be ready to redeem shares if a plan to improve on any structural concerns is inadequate or nonexistent.

Traditional issues could be breaching stated investment guidelines, changing key personnel, ethical concerns, and increasing counterparty risk. Nontraditional issues are observed systematically through intelligent quantitative tools and consist of analyzing a fund’s performance through a variety of focal points: Alpha production capacity, beta risk, performance persistency, and risk mitigation.

Through a comprehensive quantitative approach of nontraditional metrics and algorithms, portfolio returns can increase through actively monitoring managers with “Golden Hour” characteristics and changes in alpha capability. Using a walk forward methodology and incorporating fund liquidity constraints such as lock-up periods and redemption fees into the algorithm, research shows the average 12-month performance of funds in their “Golden Hour” is six percent higher than funds exhibiting deteriorating alpha capacity – indicating the end of the “Golden Hour”.

Every investment experiences performance cycles. Alternative investment managers are no exception; however, some managers never recover. Using quantitative tools and an intelligent analysis process, investors can identify the difference between temporary cyclical changes and permanent structural changes. For temporary changes, stay the course. When the winds shift and issues become structural, it’s time to consider changing course to focus on new opportunities.

For more information, visit: www.fundbase.com

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