How should you rank hedge funds

 

Most investors would say that you should rank hedge funds based on their Sharpe ratio, but there are fundamental problems with Sharpe that may not adequately measure risk. The Sharpe can be gamed with option strategies and does not account for characteristics beyond volatility. Hence, there are many who argue that using drawdown-based measures may be a better way. Research on the surface suggests that there is little difference in rank measures based on the high rank correlation across different performance measures, but a closer look says that these metrics are not all the same and picking the right performance measure matters.

Investors can classify performance measures based distributional assumption (Sharpe or Sortino) or investors can focus on drawdown analysis such as the Calmar or Sterling. Finally, there also are measures that account for the whole distribution of performance returns. Research suggest that ranking firms based on different performance is not always going to give you the same answer. See "Assessing Hedge Fund Performance: Does The Choice of Measures Matter?". This an older study that provides useful insights for investors. 

The rankings of hedge funds are highly correlated. it is found that all ranking across metrics seem to be the same with correlations well above .95. However, when there is an assessment of the equality of ranks, there is a different story.  There can be large divergences in the ranking based on different metrics. The performance measures are not all the same. Investors may mis-rank managers based on their choice of performance measure. About 1/5 of firms will move to a different rank decile based on a change in the performance measure. Nevertheless, in some cases, the rankings from some performance metrics show persistence when looked at in quartiles; however, there is no persistent when focused directly on ranks.

The traditional measures like Sharpe, Sortino, and Calmar all show persistence and seem to lead to stable rankings over time. Investors may use other measures, but an ensemble of performance metrics may be a helpful tool for rankings managers. 

Commodity prices and the dollar - The changing relationship

 

The dollar and commodity prices usually move in opposite directions. When the dollar gets stronger, there is a fall in commodity prices given most commodities are priced in dollar. The dollar rise makes commodities more expensive for importing countries and thus there is a fall in demand. However, over the last two years there has been a change in this relationship. The dollar strengthening has been matched by an increase in commodity prices.  See "The changing nexus between commodity prices and the dollar: causes and implications".

The rolling correlation has moved to a positive number over the last two years; however, the relationship is trending back to negative and is currently close to zero.  While some of this change is a function of recent shocks, there is also the key difference in US oil flows. The United States is now a net energy exporter.  Higher oil prices have increased the US terms of trade. 

Commodity exporters have done better in the current environment which has turned to commodity (oil) dollar relationship in favor of the positive correlation. This upends some traditional views between commodity importers and exporter currencies. 

Dominant Currency - Depends on a how you count dominance

There has been significant talk about the dollar losing its dominant position in global trade and capital flows. This talk happens on a regular basis when the dollar declines or there is some global event that creates questions on dollar hegemony.  It is always good to go to data to see which currencies are dominant. 

Many investors look first at the foreign exchange reserves held in dollars. That reserve number has fallen over the long-run but seems to be stable at around 60%. Capital flows are a critical number given these flows dwarf trade. International debt issued in dollars is above 60%. More countries have increased their local currency international debt given their stronger sovereign balance sheets, but the dollar is still supreme. International loans and deposits, capital flows not in the form of issued bonds, is still slightly below 60%. The dollar is still dominant for trading; however, increased stable bilateral trade allows for trading outside of the dollar. Exports using the dollar as an invoicing currency is also above 50% and the global payment currency through SWIFT is also dollar dominant. 

The second dominant currency is the Euro, yet its second place position is based on the flows across countries in the Eurozone and EMS. French trade with Spain in Euros will be booked as international currency transaction. As trade within Europe increases, the Euro grows in importance; however this may not translate to trade with other parts of the world. The yen and  Renminbi hold the third and fourth positions.

The Renminbi is likely to grow as an invoicing and payment currency based on the growing trade between China and many EM countries. This is also a place where the RMB can be used for trade financing. Given the export flow of commodities to China and the import flow of goods from China, there is a natural play for this trade to use Renminbi, yet even here, the invoicing and payment choice will be based on the particular company doing the business. A commodity firm may not want payment in RMB if they cannot convert to make their payments in local or another currency like dollar. 

The currency system is complex with network inertia causing friction against change. Will dollar hegemony decline? Yes, but this process is going to take some time. 

Sherman Kent and the problem between warner and warnee

A key part of the job of an analyst is to warn his clients about potential risks and danger. Warning also can come in the form of alerting investors about upside events.  Realize that there are two parties for any warning. There is the warner, the sender of the message, and the warnee, the receiver of the message. The form of any warning as to account for how it will be received. This problem was aptly described by Sherman Kent, the father of intelligence analysis for the CIA in his final comments. He states the problem simply, "Warning is like love - it takes two to make it."

The single central issue of warning is that it is a multi-step process which involves two parties: the Warner and the Warnee. Warning is not complete until: (1) The Warner warns (2) The Warnee hears, believes, and acts.

[There is] no warning if [the analysts’ assessment] (1) is not read; (2) is read but not believed; (3) believed but not really taken aboard.

The Warner tries to watch everything in the world and issues a warning when in his opinion the thing he sees coming up is: (1) Of considerable importance to the national security. (2) Highly likely (or likely) to take place. (3) The right time interval away - Not this afternoon. The analyst goofed—too late; Not next year—the analyst is too early. 

In examining a something [i.e., a prospective event] to tell how it meets these criteria ,you [the analysts] realize that you are judging, weighing, estimating. 

When making the next investment decision, think about the comments from Sherman Kent. There are two parties for every piece of analysis, the analyst and the investor.  What does the investor truly need to make a good decision? What is the form that the analysis should take? How can a narrative be developed that effectively communicates information on the likelihood, severity, and risk of an event. 

Perhaps being a quant saves us from this problem. Unfortunately, the forecast from analysis must be converted into a decision and that is not always easy to do.  The model provides a warning, but the PM as the warnee must use this output appropriately.

See other posts on Sherman Kent :

Sherman Kent - The analyst's analyst - Be precise with your forecasts

Sherman Kent - My guy for precision in forecasting language

Sherman Kent - the godfather of precision in forecasting language

"Likely" or "Probable" - there is a difference in language when talking about recommendations in the new year

Language, perception, and numbers - The translation problem

What does failed intelligence tell us about investing