Hedge Fund Due Diligence

No Performance Attribution of an Investment Strategy with a Judgmental Overlay

While I was heading a risk-controlled active group at a leading Bank, one of my competitors, working for a subsidiary of a leading global manager, developed a competing product which was sold as a quantitative strategy with a judgmental overlay. Their marketing (which included their parent clout) was very successful at attracting clients.

Unfortunately for their clients, the performance was very negative leading the fund to have the worst performance (last percentile ranking in a leading manager’s survey) over 3, 4 and 5 years. A client insisted in getting an attribution of performance between the model and the judgmental overlay. Results: the model had delivered positive return and the judgmental overlay’s contribution was significantly negative. One person, the director of portfolio management, was responsible for these overrides. All clients exited the underperforming strategy and the investment team was dismantled. Proper due diligence could have prevented investors from this underperformance. A successful manager needs to understand his key strengths and weakness. Can one person override, based on judgment alone, a well-designed investment strategy? (In this case, I don’t think it was a well-designed strategy in the first place.)

Clients should have asked for regular performance attribution including how much was contributed by the judgmental overlay which was not part of the backtest presented to them when they initially invested in the strategy. Backtest or not, clients should always ask for proper performance attribution to verify that the value added (if any) is in line with the marketing pitch of the manager.

For more information on proper performance attribution methodology, please contact us.

Dominic Clermont, ASA, MBA, CFA

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