Intense institutional interest in hedge fund investing has spurred many of the industry's most creative minds to develop ways to analyze, assess, measure and rank hedge fund performance and characteristics.
While at least a dozen academics are said to be at work on papers examining every imaginable aspect of hedge fund performance and its role in investment portfolios, at least three real-world practitioners have already developed tools they say identify the creme de la creme of the world's estimated 8,000 hedge funds.
Hedge fund-of-funds manager Lyster Watson & Co. LLC, New York, has applied for a U.S. patent for its hedge fund evaluator, called True α. True a uses peer group comparisons to see how much risk a manager took to achieve return and how that manager performed in various market conditions.
"We want to relate a manager's risk-related skill to the market environment," said Robert Watson, Lyster Watson president. "Most hedge fund rankings are returns-based within each strategy, but this approach does not consider risk controls or what the market environment was like for a particular strategy."
Lyster Watson manages about $1.3 billion for a client base that's 80% institutional.
Marc S. Freed, managing director, spent the last two years designing and refining the True a model. He combined three hedge fund databases with a combined 10,000 entries and eliminated duplicates and miscategorized hedge funds, leaving a list of about 3,000 "clean," single-strategy hedge funds. Indeed, Mr. Freed said cleansing the monthly hedge fund performance data is one of the firm's biggest and most time-consuming tasks.
The model uses return and standard deviation data from each manager within a style group in Monte Carlo simulations to construct a model portfolio that incorporates all possible market scenarios and return possibilities. From within what Mr. Freed called the "blob" of possible outcomes, known more formally as the portfolio possibilities set, the median is the point used as the basis to calculate each hedge fund's True α, or orthogonal index score.
Hedge funds that outperform the median in a category get a positive score, those funds that match it get a score of zero and underperformers are awarded negative scores.