Hedge Fund Due Diligence
Most Hedge Fund scandals would be avoided with proper due diligence performed by experienced managers.
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April 19, 2012: Death of a great investment counselor, Carl H. Otto
Updated: April 20, 2012
S&P STAR system with low IC
(Note that the S&P STAR ranking system that exists today may be significantly different from what it was some 10 years ago when I did my review.)
In the early 2000s, my firm was eager to launch a fund based on the S&P STAR ranking system (STock Appreciation Ranking System). US companies are ranked from 1 to 5:
When I did my due diligence, an investment in companies ranked 4 & 5 had delivered consistent outperformance. My first quick analysis involved measuring the investment skill (IC) of the STAR system. I was surprised to see that their IC was quite low at approximately 0.01 compared to my own US strategy which had an IC of close to 0.06. How could they deliver such outperformance with such low IC?
Performance attribution is the best way to verify that the value added is in line with a manager’s marketing pitch. The performance attribution showed that most of the value added of the STAR system came from the portfolio construction! Back then, the initial portfolio of companies ranked 5 was formed equally weighted and then each stock’s weight would drift according to its performance. For example, if 100 stocks are present in the initial portfolio, each has a 1% weight. After a year, some stocks with great performance may have drifted to say 2%, while some underperforming stocks may have seen their weight lowered to say 0.4%. Thus, at any point in time, the portfolio was overweight stocks that had done well, and underweight stocks that had underperformed. In other word, the portfolio was betting on … momentum. And the performance attribution showed that most of the value added came from that, not from the STAR system.
Since then, S&P has changed its portfolio construction and is now rebalancing to equal weight on a monthly basis. They must have worked on improving their investment skill (IC) in order to deliver performance.
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Dominic Clermont, ASA, MBA, CFA
State of the Art Investment Management