Hfr 11april 2001 Young Funds Report

7/31/2019 Hfr 11april 2001 Young Funds Report

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Absolute Return Fun d Research Ap ril 2001

T h e Yo u n g O n e s

Man y in vestors assum e that young funds perform better th antheir seasoned counterparts. H owever, the issue of survivor bias

muddles the exact degree of out-performance. In this report, we

show the results of a database screening that compares hedge

fu nd perform an ce by m aturity ad justing for survivor bias.

Young fund s do outperform . And the results strongly suggestm akin g an investment in the first th ree years of a fund s life.

M a in P o i n t s

Youn g fun ds ou tper form seasoned fun ds a fte r

ad jus tmen t fo r r i sk of fa i lu re

Fu nd fa i lu r es pea k a t 28 month s

Adju stin g for sur vivor bias , th e youn gest d ecile

bea t s th e o lde s t by 970 ba s is po in t s pe r an nu m

Inves tor s should bu y youn g fun ds in th e fi rs t t h r ee

year s of th e i r ex is tence

Figur e 1 . Hedge F un d R etu rn s (Una djusted ) By Age Decile ,1994-2000

Decile Median Age Average Annual Return

1 13 23.2%

2 19 20.53 25 18.2

4 32 17.2

5 38 18.3

6 47 15.4

7 57 13.4

8 70 14.6

9 90 12.7

10 142 11.7

Median 43 13.4

Source: CrossBorder Capital, TASS/Tremont

CR OS SB O R D E R CA P IT A L


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The Youn g Ones

April 2001, Page 2 of 7 CROS SBORDER CAPIT AL

Many investors bel ieve that young hedge funds1

per fo rm

bet t e r than long-es tab l i shed hedge funds . Several reasons ar e

provided, such as th e existen ce of a tem pora ry niche th at is ultimat elyar bitra ged away; th e higher en ergy devoted t o perform an ce by a newentrepreneur, and then the adoption of a more conservativeinvestmen t a pproach once the ma na gers m assive performa nce fees

have been invested in the fund. However , a wor r y ing coun te r -

a r gumen t focuses on sur v ivor2

b ias in the da ta samples . Itsuggests that there is likely to be a higher failure rate among newfun ds, an d a fun d t ha t fails, by definition, falls out of the da ta base.

Some st udies ha ve shown t ha t sur vivor bias ma y add or su btra ct a s

mu ch as 2% to aggregat e hedge fun d sta tistics3. If youn g fun ds h ave a

still higher failur e ra te, t heir survivor bias is likely to be great er.Consequently, returns from investing in younger funds may proveun at tr active once th is risk of failur e is factored in.

Clearly, this is a proposition that is worth testing. Using theTASS/ Tremont data base for the 1994-2000 period, we first screened

accordin g to age decile. The r esu lts for 3,733 fun ds, shown in Figur es1 a nd 2, reveal a m edian r etu rn of 13.4% for a ll deciles an d a medianret ur n of a whopping 23.2% for t he youngest decile. In oth er words,there is a massive spread of around 980 basis points in favour ofyoung funds.

Figur e 2 . Hedge F un d R etu rn s (Una djusted ) By Age Decile ,1994-2000

Source:CrossBorder Capital, TAS S / Tremont

1Usually defined as those offering a track record of less than three years.

2Also known as survivorship bias.

3A n egative or down ward bias to future returns occurs w hen a very successful

fu nd closes to new m oney an d so fails to m ainta in its voluntary reporting. A

positive or upw ard bias takes place when a poorly perform in g fu nd closes

down.

y = -0.0482Ln(x) + 0.3457

R2

= 0.9262

10%

12%

14%

16%

18%

20%

22%

24%

0 20 40 60 80 100 120 140 160


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CROS SBORDER CAPIT AL

Th e Young Ones

April 2001, Page 3 of 7

The above data make a strong case for investing in young funds.However, it ha s n ot been adjusted for su rvivor bias. Sceptics suggest

that positive survivor bias unfairly flatters young funds because

their allegedly higher failure rate is not captured in these crudefigures. The scep t i cs a r e w rong .

Figures 3 and 4 show the incidence of failure4

by age (i.e. th e point

when reporting st opped). Of th e original 3,733 fun ds th at reported in1999, 341 or 9.1%, for some reason, failed to report in 2000. Th e

brea kdown of th i s subse t o f fun ds by age r evea ls a n o t i ceab ledi f fere nce in fa i lur e ra tes betw een youn g an d season ed

f u n d s . Fa ilure in th e first year was, not sur prisingly, low: ma na gerswere able to struggle on. Failure in year two was correspondinglyhigher. In each subsequent year, the failure rate fell. Overall, the

probability of failure during the first three years at 4.2% was onlyslightly less than the 4.9% probability of failure for years four

onwards. The large proportion of failures reported in year six andabove (25.1%) is simply an aggregat ion of fun d failures aged s ix year s,

seven years, eight years , etc.

Figur e 3 . Inciden ce Of Fa i lur e By Age

Age (Years) Proportion of All

Failures (%)

1 or less 7.4

2 20.33 18.6

4 15.8

5 12.9

6 and above 25.1

Source: CrossBorder Capital, TAS S / Tremont

Figur e 4 . Inciden ce Of Fa i lur e By Age

Source: CrossBorder Capital, TAS S / Tremont

4Failu re is used generically in t he sense of failu re to report.

10 20 30 40 50 60 70 80 90 100 110 120 130 140 1500

2

4

6

8

10

12

14

16

18

20

22

24

26

28

% of All Failures

Months


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The Youn g Ones


The regression line fitted to the data in Figure 4 shows that thefailure rate of hedge funds rises to a peak at 28 months and then

decays at a roughly constant rate of 2-3% points per annum. These

probabilities of failure (i.e. failure to report) can be applied tosurviving funds to create a return series that shows the true costsan d benefits of invest ing in fun ds of specific ma tu rit ies. The first twocolumn s of Figures 5 exclude a ll fun ds t ha t r eport ed in 1999 but failed

to report in 2000.

This adjustm ent covers funds th at only report ed in 1999, but n ot in2000, as well as funds that reported from 1994-99 and not 2000. It

should capt ur e both negat ive (i.e. good funds th at close) and positive(i.e. bad funds t ha t fail) su rvivor bias. Both t ypes of bias a re likely t o

affect youn g fun ds. Ma na gers th at kick-off on th e wrong foot ma y be

forced to close down in the first year-or-two, thereby dragging downthe true performance of the median young fund relative to older

fun ds. Equa lly, successful new managers may quickly att ra ct fun ds. Ifthey then close to new money, it is probable that they will stop

report ing their good perform an ces.

Young funds suffer most from negative survivor bias. Yetthe re i s su rp r i s ing ly l i t t l e d i f f e rence be tween the two da ta

se t s . The dat a for su rviving fun ds slight ly reinforce rat her th an dilut ethe case for young funds: around % per annum is added to theperformance of the youngest three fund deciles after this first

adjustment.Across th e ent ire sam ple of 3392 fun ds t he m edian ex post

ret ur n only rises a ta d to 13.6% from 13.4%.

However , these ex post numbers do no t show the expec ted

re tu rn s from inves t ing in d i ffe ren t aged h edge fun ds . These arereport ed in t he final column of Figure 5. Expected or ex ant e returnsar e calculated by mult iplying th e su rvivors ret ur ns by theprobability of future survival by age decile. We have assumed twothings: (1) all failures are bad funds that fail, and (2) 30% of initial

capital is lost5. These majo r cons t r a in t s exaggera te the

und erp er form an ce o f fa i led fun ds6.

None the less , even wi th these h eavy cons t r a in t s , t he expec tedre tu rn s shown in F igur e 5 ma ke a p e r sua s ive case fo r youngf u n d s . The youn gest decile genera tes a n expected ret ur n of 21.5%, or

5 Anecdotal evidence suggests that a fund that loses 30% of starting capital will likely

close6

Exp ected return s are constru cted as surv ivors return tim es surviva l rate in

decile a less in itial capital t im es failu re rate in decile a, e.g. for decile 1:

23.8% x 0.991 - 100% x 0.021 = 23.6% - 2.1% = 21.5%.


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Th e Young Ones


760 basis points above the (estimated) median7

of 13.9%. Thiscompares to 980 basis points for the crude data. T h e sp r e a d

be tween the younges t and o ldes t dec i l es in the ad jus ted

sam ple i s 970 ba sis points , compa re d t o 1,150 basis point s int h e c r u d e d a t a . For the second youngest decile, the excess returnover th e median drops to 290 basis point s, against 710 basis pointsaccording to th e cru de dat a.

Conclus ion : Ca tch A Ris ing S ta r

Youn g fun ds or rising sta rs should be a par t of hedge fun d investors

portfolios. Ther e i s we l l-es t ab l i shed an d cons tan t e ros ion o f pe r fo rmance wi th t ime and matur i ty . The case looks more

compel l ing once the per fo rmance da ta a r e ad jus ted fo r

sur vivor b ias . Regression results strongly suggest that risingsta rs should be capt ur ed in the first t hr ee year s of th eir existen ce.

The (logarithmic) regression data shown in Figure 7 indicates that

each 10% increase in the age/maturity of a manager reduces thepotential return by around 0.4%. Thus, between years 1 and 2,

potent ial ann ua l retur ns dr op by around 4%; between years 2 and 3 bya furth er 2% and between years 3 an d 4 and years 4 and 5 by another1%, respectively.

Figur e 5 . Hedge F un d Ret ur ns (Adjusted For Sur vivor Bias) ByAge De cile, 1994-2000

Decile

Median

Age

Sur vivorsAnnu al

Avera ge Retur n (ex

pos t )

Probabi l i ty

of Fai lur e

Pr obabi l ity of

Succes s

E x p e ct e d R e t u r n

(ex an te )

1 13 23.8% 0.9% 99.1% 21.5%

2 19 20.8 1.6 98.4 16.8

3 25 18.7 1.8 98.2 14.2

4 32 16.9 1.8 98.2 12.5

5 39 18.9 1.7 98.3 14.7

6 47 16.8 1.5 98.5 13.1

7 58 13.3 1.2 98.8 10.4

8 71 14.5 0.9 99.1 12.4

9 90 13.1 0.5 99.5 11.910 142 11.8 0.0 100.0 11.8

Med ian 43 13.6 1.6 98.4 13.9

Source: CrossBorder Capital, TASS/Tremont

7A sample median does not exist. Consequently, we have estimated a median

valu e by inserting th e median age of the survivors sam ple into a regression

equation that calculates expected returns by age.


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The Youn g Ones


Figur e 6. Hedge Fu nd Retu rn s (Adjusted For Survivor Bias) By Age De cile, 1994-2000

Source: CrossBorder Capital

Figur e 7. Regr ession Ana lysis Betwee n Age And P erform an ce,

1994-2000

Hedge Fund Data Alpha Beta (log) R-Squared

Unadjusted 34.6% -4.82 92.6%

Adjusted for Survivor Bias 27.3% -3.56 65.4%

Source: CrossBorder Capital

y = -0.0356Ln(x) + 0.2729

R2 = 0.6542

8%

10%

12%

14%

16%

18%

20%

22%

24%

26%

0 20 40 60 80 100 120 140 160

Expected Returns (ex post) Survivors' Return (ex ante)


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Th e Young Ones


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This document researches a fund not authorised or recognised as a collective regulatedinvestment scheme for the purposes of the UK Financial Services Act 1986 and is therefore forprivate circulation only and is not intended and must not be distributed to private investors. Itis for information purposes only and does not offer any specific investment advice. Under nocircumstances should it be used or considered as an advisory or offer to sell or a solicitationof any offer or advisory to buy any securities. The information in this document has beenobtained from sources believed reliable, but we do not represent that it is accurate orcomplete, and it should not be relied upon as such. In addition any information containedherein does not imply any knowledge of the entire universe of such funds and CrossBorderCapital may or may not receive a fee from the fund manager for the promotion of such funds.Deduction for charges and expenses may not be made uniformly through the life of theinvestment.

As a high volatility investment this fund may be subject to sudden falls in value and these

could lead to a large loss on realisation which could equal the amount invested. An investor inthe fund will not be liable to compensation for any losses. CrossBorder Capital point s out thatthe value of all investments and the income derived therefrom can decrease as well asincrease (this may be partly due to exchange rate fluctuations in investments that have anexposure to currencies other than the base currency of the fund). In addition that fund mayfrom time to time use options, futures and warrants which are highly specialised activities andentail greater than ordinary investment r isks. Thus a relatively small movement in the price ofa security to which these relate may result in a disproportionately large percentagemovement, unfavourable as well as favourable, in their pr ice. The fund may gear itself byother means as well. Past performance is no guide to future perform ance.

Whilst given in good faith neither we nor any officer, employee, or agent of ours shall be liablefor loss or damage, whether direct or indirect, which may be suffered by using or relying onthe information, research, opinions, advice or recommendations contained herein or in anyprior or subsequent written or verbal presentations. The employees of CrossBorder CapitalLimited may have a position or otherwise be interested in funds mentioned in this report . Thisreport may not be reproduced, distributed or published by any recipient for any purpose.CrossBorder Capital Limited is regulated by the SFA for the conduct of investment business inthe UK.

Hfr 11april 2001 Young Funds Report

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