On Average We Are All Average
The year 2015 is now officially over, and as mentioned last month, it was the year of zero returns, or so it seems. On average this appears to be accurate, but we all know averages can be misleading. The S&P 500 Index earned a meager 1.37%, while the MSCI EAFE Index was down 0.21%. Traditional bonds were roughly flat, as the Barclay’s Aggregate Bond Index gained 0.55%. However, dipping down in credit quality proved costly, as high yield bonds were down roughly 5%. If you had equity exposure to small companies, things start to look a bit different from “average.” The Russell 2000 Index was off 4.41%, and it gets even worse if you had a value tilt, as the Russell 2000 Value Index was down more than 7%. While developed international markets were flat, the MSCI Emerging Markets Index lost nearly 15%. Using other “diversifying” asset classes such as oil, gold and MLPs left you down more than 30%, 10% and 32%, respectively. It seems 2015 had more than a few land mines in the way of “average.”
Traditional hedge funds also struggled to earn positive returns, as the HFRI Fund Weighted Composite lost roughly 1% during 2015. The HFRI Macro Systematic Diversified Index lost more than 2%, while the HFRI Equity Hedge Index lost nearly 1%. Event-driven funds fared even worse, losing more than 3% on average (HFRI Event-Driven Index) with distressed managers down 8% (HFRI ED: Distressed/Restructuring Index). And to top it off, some of the most respected and historically best performing hedge funds had a 2015 that approached or exceeded 2008 losses.
Similarly, hedge fund’s liquid counterparts didn’t fare any better. Morningstar’s institutional category returns were underwhelming at best, as only two categories were able to eke out a positive return. These were Diversified Arbitrage and Equity Market Neutral, which each earned less than 1%. The largest category, Long/Short Equity, lost just over 1.5% during the year, while the second largest category, Multialternative, lost about 2.5%.
Again, all of the above numbers are averages. What may be more intriguing is the dispersion among managers in these categories. While the Long/Short category posted an average loss of about 1.5%, the top 5th percentile manager returned nearly 9%, and the bottom 5th percentile manager lost more than 12%, resulting in dispersion exceeding 20%. Beyond the fifth percentile, there were several managers down more than 20%. To make matters worse for investors, many of the funds at the bottom were among the largest funds, so the returns investors realized were likely much lower than the category average on a dollar-weighted basis.
So despite 0% average returns for the largest asset classes and many alternative strategies, investors were likely to have posted losses in 2015. In the last six years most asset classes have experienced strong growth, but as 2015 has shown, there will be years when positive returns are difficult to come by. The lesson for investors doesn’t change from month to month, so our conclusion last month is just as important this month. Investors who have prepared for volatile times through thoughtful portfolio construction, and those who have stuck to their plan will have reduced the chance of realizing large losses, allowing them to weather bouts of volatility such as we find ourselves in today.
Avenue Quits Reporting Daily Asset Levels
In the wake of Third Avenue suspending redemptions, Avenue Capital has decided to quit reporting asset levels of its Avenue Credit Strategies Fund to the mutual fund industry’s top two tracking firms.
People familiar with the situation said outflows from the Avenue Capital fund had become a distraction after an unrelated junk bond fund run by Third Avenue Capital Management imploded in early December. Junk bond investors already were on edge, pulling $3.6 billion from high-yield funds in November, according to Morningstar data.
Avenue Capital’s fund was particularly hard hit after Third Avenue said on Dec. 9th it was liquidating its Focused Credit Fund. Investors reacted by yanking $262 million from the Avenue Capital fund during the first two weeks of December, according to Lipper data.
Whitebox to Close Their Alternative Mutual Funds
Whitebox is liquidating its three liquid alternative funds after suffering from poor performance, redemptions and manager departures. The firm has made a strategic decision to exit the liquid alternative business in order to focus on their more profitable $4 billion traditional hedge fund business. Whitebox wasn’t the only firm to shutter funds in 2015; 31 funds were liquidated during the year, compared to 22 funds in 2014.
Not Everyone is Shutting Down Funds
Balter Capital Management has announced they will be converting two existing hedge funds into mutual funds; a European Long/Short Small Cap Fund and an Event-Driven Fund:
The Balter European L/S Small Cap Fund is sub-advised by S. W. Mitchell Capital, a $2 billion European equity specialist based in London, noted the asset manager in a statement. The fund has an 8-year record as hedge fund and an annualized return of 10.6%, according to Balter, utilizing a bottom-up fundamental security selection process.
The Balter Event-Driven Fund is sub-advised by Tiburon Capital Management, a $75 million hedge fund based in New York. The fund has a 5-year record and an annualized return of +8.3%, according to Balter, and uses proprietary investment methodologies to evaluate event-driven opportunities, including bottom-up analysis of capital structure and potential revaluation catalysts.
Attain Capital put together an informative piece explaining drivers of performance for managed futures funds in 2015. Definitely a worthy read.
Peer groups are widely used to evaluate funds, but are far from ideal benchmarks, as pointed out in this article, which was part of the CFA curriculum a number of years ago. All returns come from exposure to risk, and as such, in order to judge the efficacy of a strategy, you have to understand the risk exposures that drive returns. The less homogeneous the category, the less homogenous the risk exposures, and thus the less reliable the category average and peer group are for the purposes of measuring the value add of a strategy.
Given how nascent the alternative mutual fund world is at this point, the peer groups that investors turn to when evaluating performance are even less useful than they are for traditional, long only strategies. Take Morningstar’s Long/Short Equity category as an example. While Morningstar has nine style boxes just for diversified U.S. equity funds and another six style boxes for international diversified equity funds, long/short funds of all stripes are lumped into a single category. Digging through the peer group you’ll find financial and healthcare sector funds, European small cap focused funds, covered call funds, global funds, emerging market funds, those with static exposures and those with wide ranging exposures, and on and on. It is in large part for this reason that dispersion within the category is so pronounced, as mentioned above, and it makes the peer group all but useless.
But there are signs of evolution in the way the mutual fund database providers are thinking. According to Ignites, Morningstar recently announced that they would add a number of new categories in April, among them: Option Writing and Long/Short Credit. We see this as a step in the right direction, as covered call strategies are clearly not Long/Short Equity Funds and Long/Short Credit is materially different from most Nontraditional Bond Funds. It’s a start, but there is a long way to go. So as you evaluate funds already owned, or are researching new funds to fill out your allocations, resist the urge to rely on category rankings. Picking this year’s winners without understanding how the strategy differs from its peers will undoubtedly end in tears.
- If the above is true, there is about a 0.04% chance of observing this outcome.
- However, if you have 15 years of NFL football games, our very rough calculations estimate that there is a 71% probability of observing at least one team with this winning percentage. (We made a million assumptions here, don’t check our math!)
- Finally, if you do observe a team with this coin-flip winning percentage, we’ll hazard a guess that there will be close to a 100% probability it will be the New England Patriots…at least so long as Belichik is there.
- Go Broncos!
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