How to Evaluate your Hedge Funds like Ontario Teachers'

Evaluating a hedge fund’s impact on an institutional portfolio is not as straightforward as some might think due to constraints left out by most models, according to research.

In a paper titled “A Simulation-Based Methodology for Evaluating Hedge Fund Investments,” Christophe L’Ahelec, assistant portfolio manager at the Ontario Teachers’ Pension Plan and Marat Molyboga, director of research at Efficient Capital Management, set out a method they claim pension funds can use for insight into real-life scenarios—and how their investments are actually working.

“This paper introduces a large scale simulation framework for evaluating hedge funds’ investments subject to the realistic constraints of institutional investors,” the authors said.

They claim the method is “customizable to the preferences and constraints of individual investors, and includes investment objectives, performance benchmarks, rebalancing period, and the desired number of funds in a portfolio.” It can also incorporate a large number of portfolio construction and fund selection approaches, the paper said.

The approach accounts for the delay in hedge fund reporting—set out in a previous paper by Molyboga and colleagues—and “incorporates common investment constraints when creating and rebalancing portfolios.”

The framework imposes the standard requirements of institutional investors regarding track-record length and the amount of assets under management, the authors said. It also limits the number of funds in a portfolio and their turnover by assuming that an institutional investor selects a specific number of funds that stay in the portfolio until they no longer satisfy selection criteria.

In the course of their research, L’Ahelec and Molyboga found managed futures strategies improved the performance of a portfolio, regardless of portfolio construction approach.

“For the out-of-sample period between January 1999 and December 2014, a 10% allocation to managed futures improves the Sharpe ratio of the original 60/40 portfolio of stocks and bonds from 0.376 to between 0.399 and 0.416 on average, depending on the portfolio construction methodology,” the authors said.

Minimum risk portfolios performed the worst for all performance metrics, the paper reported. “For example, their average Sharpe ratios are between 0.299 and 0.304, significantly lower than the 0.319 average Sharpe ratio of the random portfolios from both an economic and statistical perspective.”

By contrast, equal risk methodologies delivered superior average Sharpe ratios of 0.342 to 0.362.

The authors claimed each pension could tweak the framework to its own specific needs. To do so, download the paper from the SSRN website.

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