Hedge funds can be as complex as rocket science, so it's comforting to know that a former rocket scientist is trying to make them easier to understand. Ron Surz, president of San Clemente, Calif.-based PPCA, thinks performance evaluation tools for hedge funds are woefully inadequate. Here's what he's trying to do.
Registered Rep: What's the biggest problem for advisors who want to get clients into hedge funds?
Ron Surz: In a nutshell, understanding what the manager is doing. A lot of hedge fund managers hold out this mystique and are reluctant to tell you how they're making the money.
RR: What's the problem with how performance has been measured in the past?
RS: The problem exists on the traditional side (long) and multiplies on the nontraditional side (long-short strategies). It's no secret that peer groups on the traditional side are problematic at best. When you try to bring this already lousy backdrop of peer groups and move it to the nontraditional side, it gets to be a joke.
RR: What is the solution, then?
RS: It's an application of classical stats, namely hypothesis testing, which views the whole issue as a test where the hypothesis is, “performance is good.” We're creating portfolios at random, run by monkeys. We create 10,000 hypothetical portfolios and that becomes all the things that could have happened; then to test the hypothesis, you take what happened and stack it against all the things that could have happened. You enter returns, the level of long positions, short positions, and your leverage. This spits out a performance report.
RR: What if you don't have all that information?
RS: It's funny — some people look at it and say the manager doesn't have that. In that case, I don't understand the investment. If you want to invest in mystique, God bless you, but I hope you've got the stomach for a crazy ride.