Contributed by Joel Parrish of Shinnecock Partners
Abstract (download the full white paper below)
Some have asserted that monkeys with typewriters, given enough time, could replicate Shakespeare. Don’t take the wager. While other financial denizens sarcastically note that given enough time there will be a few successes out of all the active money managers, building on the concept that even a blind pig will occasionally find a peanut. Alternatively, our goal in the white paper is to more reliably accelerate an investor’s search for sound and safe hedge fund and niche investments. We welcome all comments, suggestions and criticisms, too. Not kidding, really do! A brief abstract follows:
Quantitative analysis is an important part of the hedge fund investment process that we divide into four steps: 1) data acquisition and preparation; 2) individual analysis; 3) comparative analysis versus peers and indices; 4) portfolio analysis.
Step One: Data Acquisition and Preparation
Understand sourced data by carefully reading all of the associated footnotes, considering who prepared it (whether the manager, the administrator or an auditor/review firm), and evaluating the standard of preparation, e.g., is it GIPS compliant?
Step Two: Individual Analysis
Here, we compare and contrast Compound Annual Growth Rate (CAGR) to Average Annual Return (AAR), discuss volatility measures including time windowing and review the pros and cons of risk/reward ratios.
Step Three: Comparative Analysis
Any evaluations must be put into context. What are the alternatives, with greatness being a relative value.
Step Four: Portfolio Analysis
Too often, a single opportunity is considered in isolation, whereas its impact must be measured against a total portfolio of existing positions. Diversification requires non-correlation yet best to understand the alternative ways to measure it. Lastly, Modern Portfolio Theory (MPT) is heralded as the sine qua non. However, Behavioral Portfolio Theory (BPT) offers a “not so fast” but…
Quantitative observations should be confirmed whenever possible with qualitative explanations. Quantitative analysis should continue to be performed on a periodic and ongoing basis, not just prior to investment. Perfect application of all mathematical principles does not guarantee success as markets or managers may change over time, but quantitative analysis increases your likelihood of success and is a vital component of the investment process.