NEW YORK — Using a non-linear, factor-based model rather than a returns-based approach would have helped would-be investors identify and avoid so-called “time-bomb” hedge funds and significantly improve performance during the recent credit crisis, according to analysis from Riskdata Inc.
Researchers at Riskdata, which provides risk tools for hedge fund investors, studied what performance would be like if an investor reduced exposure to hedge funds that experienced poor performance after late July 2007 when market turmoil began in earnest. The purpose of the study was to try to flag hedge funds — what researchers termed time bombs — that didn’t exhibit any large performance drops in their track records prior to June 2007 but which might experience a “massive draw-down” in performance under extreme market conditions.
Riskdata applied a non-linear, factor-based approach that modeled the relationship between market factors and manager returns to the performance of 3,200 hedge funds and funds of funds between July 2007 and March 2008. All the funds in the universe had to report their data to Chicago-based database Hedge Fund Research Inc. and have minimum track records of four years. The process identified hedge funds that had predicted risk, based on the long-term risk of underlying factors, that was significantly higher than the fund’s previous maximum decline, according to the report.
“By using this criterion, an investor can eliminate funds where predicted extreme risk (using all factor history) is more than twice the observed past maximum draw-down or 2.3 times the fund’s volatility,” said the report’s authors.
Using performance of the funds in the universe for the nine months ended March 30 as the study’s benchmark, Riskdata researchers found that a portfolio that excluded time bombs would have returned 4%, compared with 0% for the entire sample.
“Delivering 4% of excess return vs. an iso-allocated benchmark (in which all funds are equally weighted) of more than 3,000 funds is an incredible result,” said Olivier Le Marois, Riskdata’s chief executive officer, in the report.
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