Real Risk Valuation vs. Sexy Reports Print E-mail

In the universe of software applications for investment analysis there are two distinguishing trends: tools designed to provide a deep insight into the matter and products designed to make impressions. The latter dominates the industry, thus opening an apparently naive question - why do investors need analytical tools and applications? To provide an unbiased research and the basis for an investment decision, perhaps? Not always so.

The market is overfilled by a huge range of analytic products having one thing in common - a bias toward a presentation and reporting engine, while the core functionality and methodology of analysis become a last priority. Nowadays, nobody argues that hedge funds are unique investment vehicles exhibiting unique properties and, threfore, requiring unique analytical tools. One may find hundreds of studies proving non-normality of hedge fund distributions of returns and, as such, inapplicability of the conventional frameworks like the mean-variance theory. There are tons of references to numerous biases of hedge fund indices, which lead to uselessness of the entire Tactical Asset Allocation framework. So, why do the major market players ignore all this?

The answers are not so obvious and, for sure, will be hated by many:

1. Many institutions employ analytic platforms primarily addressing two needs:

  • To comply with the industry standards and pass due diligence requirements
  • To make nice-looking reports for senior management that often have vague understanding on the subject.

2. Institutions are still driven by wild incompetence, when it comes to alternative investments. For more discussions on that subject click here.

3. For software vendors, it is easier to incorporate tons of various report formats or add hundreds of useless statistics replicating the same information than change its core methodology. It is not a secret for anyone that most vendors outsource developments to India and other developing countries. The only outcome one can get from there (if any at all) is technical programming, not a deep methodology. Unfortunately, this represents a devastating global trend across many industries, when the sole target of extra profits overlaps quality issues.

4. For years, institutions invested into top institutional hedge funds with low volatility creating an enormous web of cross-investments. This, in turn, resulted in a higher correlation across the board, thus making fund selection relatively irrelevant. In other words, it doesn’t really matter - in what institutional fund to invest, the portfolio performance will be more or less the same. Obviously, such investment decisions do not require any real risk evaluation, therefore, making the reporting part most important.

5. Generating thick (one-click) reports makes an illusion of titanic work of investment analysts. It is a highly desirable feature for many mediocre advisors with no viable expertise in the subject. We happen to know institutions employing former police officers or bachelors of Fine Arts (no finance background as such!) as investment analysts. Should we expect these 'experts' to value anything except impressive, but shallow reports? Probably, not.

We deliberately do not want to delve into the detailed analysis and comparison of different software platforms, because it is a subject of another discussion. Let’s just take a quick look at the leading market platform - PerTrac. While we highly respect a gigantic scale of its options, functions and reports, the bottom line is simple: as long as the main evaluation metrics are based on the mean-variance framework, it becomes largely useless for hedge fund analysis. What is the point to compare two funds using the standard deviation, if one shows a positive skewness and another - negative? What is the whole point of strategy allocation based on the declared index strategy, if hedge funds are low (or not) correlated with their indices? The list of such questions is endless...

So, where does this problem leave a hedge fund investor when choosing a right application framework? The answer is simple. If you need a sexy-looking 3-dimensional charts to impress your boss, go after any platform providing more presentations as the key requirement. If, however, you are after a deep and unbiased insight into hedge fund risks, take a closer look at what is inside, whether the core methodology could be applied to your assets. Very simple.