Which Metrics Matter for Hedge Funds?
Which is more important to a hedge fund manager: how often they‚Äôre right, or how much they make when they are? Find out using our platform.
Soros Said it Best
Which is more important to a hedge fund manager: how often they’re right, or how much they make when they are?
George Soros said it best in his famous quote:
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
Our data shows that he’s right.
The Two Metrics Explained
How often a manager is right can be viewed as the number of trades that make money versus the number of trades that don’t. However, in a world of rising markets, it’s also important to consider outperformance. Taking this into consideration, we should view how often a manager is right by the number of trades that outperformed relative to the benchmark.
The second concept, conviction, deals solely with the bottom line. This is the amount of capital you put behind your winners compared to the amount behind the losers and how you time your exit. Investors often refer to it as “letting your winners run and cutting your losers short.”
These two concepts can be quantified using two simple metrics: batting average and win/loss ratio. We calculate these (and countless others) for thousands of active managers every day. In fact, they’re the first metrics Novus clients look at when analyzing their managers, or when managers analyze their own investment process through the Novus platform.
Using public ownership data on 1,000 hedge fund portfolios, we calculated the batting averages and win/loss ratios as well as simulated performance (also based on public ownership). What we found is interesting, to say the least.
This may shock you, but the average hedge fund manager is more often wrong than right. This is true at least on a relative basis, adjusted by the S&P1500 sector benchmark performance. In nine out of the past ten years, hedge funds have chosen stocks that more often underperformed their sector benchmarks. The one exception was 2009, a good year for hedge funds by many measures. The overall picture, however, is pretty disappointing for investors, considering we pay hedge fund managers hefty fees to manage money and pick great stocks.
In the following chart, we see the difference between the average hedge funds’ batting average and that of a passive benchmark, normalized to 50%. A value of zero is what you would get by investing in the S&P 1500. So in 2005, hedge fund portfolios’ batting average was 47%. That number minus 50% for the passive benchmark will give you -3% underperformance, plotted on the chart.
But one look at the win/loss ratio for the same hedge fund universe will shed light on how hedge funds make their money, and exactly why they earn their high fees. In all ten years, managers generated positive win/loss ratios relative to passive benchmarks. This means that the average contribution on their outperforming stocks was always greater than the average detraction from their underperforming stocks. That is a strong case for active management—the ability to ride the winners and cut the losers. Take a look at the following chart of annual relative win/loss numbers:
A win/loss of one is what you would get from the S&P 1500. Every year, hedge fund managers made more on their outperformers then they lost on their underperformers. At the same time, we can clearly see why 2008 and 2011, and now more recently 2014, have been challenging years for hedge funds. Their usual “watering your plants and cutting your weeds” behavior did not contribute as much as it has historically.
Looking through this lens we can see that George Soros had it right when it comes to active management. What ultimately matters is how much you make on your winning trades, not how often you’re right.
Both allocators to hedge funds and hedge funds themselves can benefit from looking at their investment process through this lens. Do you know which managers offer you highest win/loss ratios for your fees? If you are a manager, what are your batting averages and win loss ratios by sector? How about by market cap, liquidity bucket, or even by analyst? Novus clients have this information at their fingertips, and it makes a world of difference. It gives them the power to understand the areas where they add value, and find areas where even more value can be harvested.
We have just released our rankings for the Best Hedge Funds in Q1 2015. Take a look and see if you made the list!
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