Looking Sharpe

Adam M. Grossman

WHEN ASKED WHY HE robbed banks, Willie Sutton replied, “because that’s where the money is.”

Similarly, private investment funds—such as hedge funds and private equity funds—are attractive to high net worth investors, because they carry the potential for outsized returns. That, supposedly, is where the big money is. Several factors explain this potential. Among them: These funds not only use leverage to increase the size of their investment bets, but also they may buy investments that aren’t publicly traded—and hence they could receive higher returns because these investments are mispriced or as an inducement to accept their illiquidity.

But private funds also carry outsized risks. And it’s not just the Madoffs of the world that bear watching. Plain old incompetence can also bring down a private fund. The reality is, as a prospective investor, you are at a distinct disadvantage in assessing the risks involved. Not only do fund managers have much more information about their own fund than you do, but even the information they disclose is often insufficient.

Consider the Sharpe ratio, a statistic intended to summarize a fund’s risk-return profile in one easy number. Hedge funds and other private investment funds universally cite this statistic in their marketing materials, with a high Sharpe ratio suggesting the fund delivers good performance relative to its risk. Sounds great. It turns out, though, that the Sharpe ratio can be highly misleading.

Sophisticated investors understand this. David Swensen, the acclaimed manager of Yale University’s endowment, is on record saying that he doesn’t bother with Sharpe ratios because it’s apples-to-oranges to compare publicly traded stocks to private funds holding illiquid investments, such as real estate, private equity investments and nontraded loans, that aren’t priced every day. Illiquid investments have inherently lower price volatility simply because they are only reappraised sporadically.

Indeed, even the inventor of the Sharpe ratio is skeptical of how it’s used by clever marketers. In a 2005 interview, William Sharpe—a winner of the Nobel Memorial Prize in Economics—said that his ratio was being “misused” by hedge funds: “Hedge funds can manipulate the ratio to misrepresent their performance.” He added that “past average experience may be a terrible predictor of future performance” and that “no number can” help investors fully understand a fund’s potential risk.

A case in point: Integral Capital. In 2001, the venerable Art Institute of Chicago became smitten with this hedge fund’s 32-year-old founder and his impressive sales pitch. Integral funds, he claimed, had never had a losing month and had the highest Sharpe ratio in the industry. The museum ultimately invested $43 million into two Integral funds.

Its investment quickly turned to disaster. After suffering losses of more than $20 million, the Art Institute sued, accusing Integral of improprieties in how it allocated fund assets. Tellingly, the funds’ attorney responded that the manager “could have bet on the Super Bowl if he wanted” with clients’ money. In other words, Integral may have lost money, but it didn’t technically do anything wrong. Cold comfort.

Alternative measures are no better. For example, Frank Sortino, the creator of the Sortino ratio, a close cousin of the Sharpe ratio, has also expressed unease that his ratio is used by hedge funds for marketing purposes. “I think it’s used too much because it makes hedge funds look good,” he says. “It’s misleading to say the least…. I hate that they’re using my name.”

If you put money into a private investment fund, you need to recognize that it is, by definition, a black box. The insiders will always understand it better than you. Result: No matter how many years of terrific performance a fund may have under its belt, you can never know whether any given fund will succumb to the fate of an Integral. To be sure, private funds offer tremendous potential—but an extra dose of due diligence never hurts.

Adam M. Grossman’s previous articles include Anything but AverageProtect Your Privacy and Losing It. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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