The Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors (Part 1 of 2)

While mutual funds are required to identify a benchmark and state performance over certain time frames and against certain indices, hedge funds are not legally required to do so. As such, hedge fund managers typically do not benchmark their performance. However, pension funds and other institutional investors may assess hedge fund returns, either explicitly or implicitly, in light of a benchmark. This first article in our two-part series discusses the use of benchmarks as a performance measure, exploring if, and how, pension funds and institutional investors evaluate hedge fund performance against a benchmark. The second article will discuss the practical consequences of subjecting hedge funds to performance benchmarks; consider whether such a practice could shift the performance emphasis of hedge funds away from absolute returns toward a focus on benchmarked results; and analyze the parameters surrounding the use of benchmarks for evaluating hedge funds.

For another method of performance measurement, see “Common Practices, Benefits and Drawbacks for Hedge Fund Managers of Using Target Returns (Part One of Two),” The Hedge Fund Law Report, Vol. 8, No. 16 (Apr. 23, 2015).

Benchmarks as a Performance Measure

Historically, there has been little uniformity in the presentation of performance results by fund managers. As a result, investors have faced difficulty when comparing returns across managers. The Global Investment Performance Standards (GIPS) are a standardized set of voluntary reporting principles for performance reporting. However, while GIPS facilitate comparison of GIPS-compliant hedge funds against each other by ensuring that those funds fairly represent and fully disclose their investment performance, investors still need to obtain and examine the performance of multiple funds in order to compare them. See “CFA Institute’s Jonathan Boersma Explains the Purposes and Mechanics of GIPS Compliance by Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 8, No. 4 (Jan. 29, 2015); “Top Ten GIPS Compliance Challenges for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 7, No. 37 (Oct. 2, 2014); and “Expert Panel Provides Roadmap for Hedge Fund Managers Looking to Present Performance in Compliance with GIPS,” The Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).

Benchmarks can help investors evaluate individual funds and investment managers, both individually and against their peers. They are an important tool in evaluating all types of investment managers, providing a reference point to monitor a manager’s performance and setting a standard against which to compare investment results. Benchmarks establish a consistent measure for investors to compare the performance of one manager to another manager, or to a group of managers.

Benchmarks can also help investors judge if a manager is investing consistently in line with its professed investment style. They can also assist investors in determining their appropriate asset allocations.

Do Pension Funds and Institutional Investors Apply Benchmarks to Hedge Fund Performance?

Joseph Marenda, a managing director at Cambridge Associates, believes that institutional investors are using benchmarks to measure the performance of hedge funds. “Pension funds and other institutional investors do use benchmarks to assess hedge fund performance, and it all comes back to the need to determine whether or not those investors are doing a good job selecting managers and correctly allocating assets. The question basically comes down to ‘how I am doing versus how I have done?’”

The use of benchmarks has become prevalent in the hedge fund industry, agreed Kenneth Heinz, president of Hedge Fund Research, Inc. (HFR), stating, “Benchmarking continues to increase. It’s concurrent with the growing base of capital in the hedge fund industry and the broadening of the amount and types of investors that are investing in hedge funds. The number of investors that require a point of reference to evaluate performance is as high as it’s ever been, and it’s going to continue to get higher.”

Nonetheless, Heinz noted that benchmarks are just one of a number of tools that investors use to measure performance. “The application of a benchmark is extremely important for many investors. It tells a lot about a fund and how the investment is doing. However, performance monitoring is a multi-faceted task where you need a real comprehensive picture of all the different aspects of the investment, not just benchmarked performance.”

How Are Benchmarks Used to Measure Hedge Fund Performance?

There is some debate as to whether pension funds and other institutional investors applying a benchmark to assess a hedge fund’s performance are primarily concerned with absolute returns, or whether they are more interested in the relative returns of the hedge fund against the benchmark.

When looking at benchmarked performance, Brian Farmer, a partner at Hirschler Fleischer and a member of the investment committee for the City of Richmond Retirement System, takes a balanced approach. “As an investor, we care about absolute returns, but we also want to know how the hedge funds we invest in perform against a benchmark. We have a fairly sophisticated and good understanding of how hedge funds work, and we recognize that they are supposed to be risk-minimizing vehicles. We look at the basic hedge fund indices just to make sure the funds we’ve invested in aren’t deviating wildly from the indices. We want to make a certain annualized return so we can meet our funding requirements, but we also understand some parts of the portfolio aren’t going to perform as well in certain markets as others.”

“From the investor perspective, we look at benchmarks like the HFRI Index and the Credit Suisse Hedge Fund Index on a monthly basis to size up our hedge fund investments against those hedge fund-related indices,” Farmer continued. “We don’t take the analysis a lot farther than that, and we don’t use other indices to compare hedge funds.”

Farmer clarified that he uses benchmark information as a measuring tool to analyze the performance of the hedge fund relative to the indices and the fund’s peers. “If there is a noticeable difference in performance, we try to understand why and see if it’s because of a strategy that we intended, or if there is style drift or another problem.”

“Investors are more interested in absolute returns,” argued Robert Kaufman, a principal in the hedge fund administration department of Kaufman Rossin Fund Services, “because many sophisticated hedge fund investors understand that the benchmarks don’t necessarily hold true year to year and may not be a true comparison for how the fund is performing.” Kaufman asserted that an investor strictly evaluating fund performance relative to a benchmark would be satisfied as long as the fund’s performance exceeds that benchmark, even if the fund was actually losing money, “so that can’t be the only determinant in measuring a hedge fund manager’s performance. Benchmarks can be useful tools but they are not the most important tool in the overall hedge fund evaluation process.”

The Teacher’s Retirement System of Texas (TRS) similarly takes a rounded approach when using benchmarks as a performance measures. According to a source at TRS, “Investments are evaluated holistically, with reference to industry benchmarks, to alternatives with similar risk characteristics and to public market equivalents, along with many other qualitative and quantitative factors.”

According to Heinz, “Investors are using the indices as part of their ongoing due diligence process with respect to their allocations. They’re looking at the performance of the fund they’re invested in or considering investing in, trying to decide how that performance measures up in a relevant peer group context. Investors are looking at that performance over time, not just as a one-off thing.”

A source explained that the Ohio Police & Fire Pension Fund also utilizes performance benchmarks to monitor its hedge fund investments, assigning tracking error targets for each of its hedge fund strategies. “The alpha strategies we employ are all hedge funds or hedge fund-of-funds. Since we use them within our portable alpha structure, we have expected tracking error (and related real return) targets specific to each strategy – for example, an absolute 6% annualized performance (gross) at a targeted tracking error of 6% per year.”

As to whether investors select hedge fund managers based on the performance of their funds against a benchmark, for Farmer this is not the case. “We do not make investment decisions based on how a fund performs against a benchmark,” he stated. “We analyze the fund’s track record by looking at its absolute returns over time. Our decision to invest is based on the history of the manager, how long they’ve been in business, what kind of capital they’ve been managing and whether they’ll be able to successfully manage a large amount of capital. It largely comes down to our knowledge of the manager, our understanding of the fund strategy, who is on the team and how their operations look.”

How Do Pension Funds and Institutional Investors Select a Benchmark?

The selection of an appropriate benchmark may vary according the investor in question, and can, to a large extent, depend on how an investor is looking to utilize a benchmark in its evaluation of a hedge fund.

“Investors want to try to evaluate how a hedge fund has performed in a universe that can be either broadly or narrowly defined, depending on the benchmark and the strategy,” noted Heinz. “In some situations – particularly where the investor is looking to allocate to a fund in a particular strategy – it makes sense to have a narrowly construed benchmark, comprising strategies that have similar exposures. In other cases, if the investor is somewhat agnostic to what kind of hedge fund they want to invest in, they may simply want to look at a hedge fund that performed well in relation to all other hedge funds that are out there and therefore have a broader benchmark.”

In addition to providing a yardstick for measuring the performance of an asset class or an individual manager, benchmarks can be important tools for building and monitoring portfolios, helping investors to determine the proportions of their total capital to allocate across broad asset classes.

“Most investors spend a lot of time trying to develop a benchmark at the allocation level,” Marenda explained. “Investors with an allocation to hedge funds are looking to have some complementary benefit to their overall portfolio allocation. In some cases, it may be enhanced returns, downside protection or diversification. For example, if an investor wants to have a diversified portfolio that has low correlation to the equity markets, then the benchmark that is developed will have a low correlation to the overall equity markets. The job of the investment team is to build a portfolio of hedge funds that gets them to the right outcome.”

According to Kaufman, “Some pension funds and institutional investors ask the manager for an appropriate benchmark to compare the fund to. But it’s incumbent on any prospective investor to really drill into a fund and see what it’s trading, in order to find the benchmark that makes the most sense to that investor.” Kaufman views this practice as an essential part of the due diligence process.

“Even if a fund provides a benchmark, the investors need to carry out their own research to make sure that benchmark is relevant and accurate,” Kaufman stated, explaining that managers may have different incentives than investors when selecting a benchmark. “The fund manager may have an incentive for providing a benchmark the fund is clearly outperforming and which may not be comparative to the trading style of the fund.” This may particularly be the case where fees are tied to performance against a benchmark.