Practical analysis for investment professionals
23 April 2013

How to Choose a Good Hedge Fund for Your Portfolio: Mark Anson’s Secret Formula

Evaluating the quality of a money manager is a perennially important topic. It’s all the more important when that money manager charges 2% of assets under management and 20% of any gains. Yes, that age-old conundrum of how to choose a good hedge fund for your portfolio remains a difficult task. But Mark J.P. Anson, CFA, CAIA, thinks he has bright light to shine on the problem. As the person responsible for alternative assets at the Bass Family Foundation, he enjoys wider sight lines than many other investors who have taken the plunge into hedge funds.

At last week’s 2013 Asset and Risk Allocation conference in New York, Anson began his presentation with a Sherlock Holmes–like quote: “When you have eliminated all of the beta, whatever remains, however improbable, must be the alpha.” In other words, if you want to identify a skilled hedge fund manager, you need to dissect the many factors (betas) leading to an actual return (alpha). Unfortunately, Anson suggests, most of the recorded alpha of hedge funds as an asset class is actually an underestimation of liquidity beta.

Privately traded assets have low betas relative to public markets. The theory is this is because private market asset pricing is not driven by public market fluctuations. But Anson believes this is a ridiculous assertion. After all, private equity is affected by similar forces as is public equity: the quality and level of economic growth, the employment picture, global trade regimens, and so forth. What is different about illiquid assets is the time it takes for private market prices to reflect factors as public markets do. Consequently, when evaluating hedge fund returns, Anson uses lagged market returns. By regressing hedge fund returns for the current period plus several prior market periods, he is able to reduce much of the reported alpha of hedge funds.

“Well that’s just great,” you might say. “Now what do I do since single-period regressions are not useful for identifying good hedge fund managers?” Anson suggested a useful and simple model for evaluating the quality of hedge fund managers (or any money manager, really): The expected quality of a hedge fund manager is a function, he argues, of additional return, minimal volatility, a bias toward positive returns, and less big blowups.

If you speak quant, that formula can be written as:

E[U] = α – β1σ + β2(skewness) – β3(kurtosis)

Anson argued that this simple formula properly rank orders quality money managers and does as well as polynomial goal programming and other statistical techniques, but without the extreme complexity.


Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/retrorocket

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

9 thoughts on “How to Choose a Good Hedge Fund for Your Portfolio: Mark Anson’s Secret Formula”

  1. Mauricio says:

    Parametric, simple, and easy to implement (nice). But once we rank orders quality managers, the persistency of manager quality is not observable, and persistency is what I want to identify most, when I select a hedge fund manager. However, as a feedback tool is useful.

    1. bill says:

      the formula looks very simple
      E[U] = α – β1σ + β2(skewness) – β3(kurtosis)

      can i ask how to get the betas?

      1. Hi Bill,

        You would have to ask Anson about his technique. As far as I can remember at this late stage, though, he is simply looking at the returns of hedge fund managers relative to a benchmark, i.e. time series of returns.

        Hope that helps,

        Jason

  2. Hi Mauricio,

    Thank you for your comments, they are much appreciated.

    With smiles!

    Jason

  3. Luis A. Veras, CFA says:

    Nice and simple. But, a bit too simple, perhaps? It does not discriminate between upside and downside deviation; and also, the resulting ranking could be vague if there are several funds with extreme kurtosis and/or skewness within the list being examined. Having said that, it’s definitely a great tool to begin the selection process.

    1. Hi Luis,

      Yes, Anson raised these same concerns in his presentation. He said that after checking is old very research intensive process as compared to the formula shared above, that he did not find a deviation between the hedge funds identified in the traditional process and the above formula.

      I myself used to intern at a pension consultancy and we developed a formula for quickly identifying great managers (that included semi-standard deviation, by the way) and we only occasionally disagreed with the findings of the formula.

      With smiles,

      Jason

  4. Ben Rounds says:

    Hi Jason, where is this formula published? Is this in “the Handbook of Traditional and Alternative Investment Vehicles” or some other Anson article?

    Thanks for the help!

    1. Hi Ben,

      This article was a summary of comments Anson made at a CFA Institute conference several years ago. To my knowledge he has not published this formula anywhere else. Alas, the slides for his presentation are also not available.

      Yours, in service,

      Jason

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