MPI Blog

The goal of this week’s post is to explore the factors driving Galleon Technology fund’s performance a bit deeper. The fund was widely known for its high turnover, rapid-fire trading and extensive use of options to leverage short-term bets. Therefore, it seems unlikely that this quintessential hedge fund could resemble a typical technology sector mutual fund. But, as we’ve already learned from our previous analysis of Renaissance RIEF, such massive trading may inadvertently result in performance that can be explained by a handful of directional bets.

First, we expanded the time period from our previous post. The chart below now includes excess return information for five full years from 2004 where we’ve highlighted three months: July ’07 and ’08, which have come under heavy scrutiny for alleged insider trading and July ’06, where outperformance was notably higher than both July ’07 and July’08. Over the five year period (2004-2008) these three months were the only months when the Galleon fund significantly outperformed its peers—an average technology hedge fund in the index.

Clearly, July performance numbers for each of the three years are deemed as statistical outliers (regardless of the legal connotation) which potentially could distort any further analysis of Galleon returns. In addition, the complaint mentions July 2007 $4M gain from trading Hilton—not a technology stock—which could also “contaminate” our analysis. Given the facts above we decided to remove all three July observaions as outliers.

Next, we proceed with a dynamic forensic analysis of the Galleon Technology fund’s returns similar to the one performed in our previous post using MPI Stylus™ and its DSA engine. The results of this analysis are presented in an exposure chart below. Note that this chart does not show actual holdings, but allocations to different factors that best explain the returns of the fund.

We note quite stable long exposure to several Dow Jones technology sectors. The exposure to foreign technology companies is represented by the MSCI All Country ex. US Tech index, indicating positions in ADRs, foreign stocks, or simply sensitivity to foreign markets through investing in U.S. stocks. Short exposure to PowerShares QQQ ETF is supported by the fund’s SEC filings according to which the fund maintained at times a significant position in QQQ put options. Both the cash exposure (about 60%, an indication of net 40% market exposure) and the size of the short position (30-40%) are similar to our earlier results. At the same time, these results are slightly different from the ones in the previous post, which is expected given that we removed three very large outliers.

It should be noted that because of the removal of outliers the statistical quality of the analysis improved significantly. The R-squared statistic determining the quality of fit is 89% and the Predicted R-squared, MPI’s proprietary cross-validation statistic, is 79%. Such a high quality regression is more typical for a large, diversified mutual fund. The quality of fit is also illustrated in the performance chart below where an exposure-weighted portfolio made of factor indexes (called a “Style” or “Tracking” portfolio) closely tracks the fund’s actual performance in-sample (“Total”).

Note that the tracking is exceptionally good through the middle of 2006 where the fund and the tracking portfolio lines begin to deviate slightly despite the removal of outliers. Nevertheless, both the pattern of performance and its magnitude are captured very well throughout the entire five-year history.

While the results of this analysis are very intriguing and somewhat unexpected, the study itself carries very important lessons for investors. First, it shows that analysis of hedge fund returns is a delicate, iterative process requiring careful examination of residuals. If outliers cannot be explained by any available portfolio information they could warrant removal or winzorisation. More importantly, removal of several large “alpha” outliers allowed us to show that in the remaining periods this quintessential high-turnover arbitrageur behaved more like a diversified mutual fund, with returns mimicked by a few long-term directional bets. And while massive computer-generated trading of Renaissance RIEF resulted in such an immediately apparent pattern, in the case of Galleon, the long-term directional pattern became visible only after identification and removal of several exceptional returns.

Daniel Li, PhD contributed to this research.

Michael Markov Hedge Funds, Main

The pattern in alpha is as important as its magnitude…

Daniel Li
Michael Markov

In the recent insider trading scandal involving the founder of Galleon Group, Raj Rajaratnam, the government used wiretaps to secretly record his phone conversations and those of his alleged accomplices. In the complaint, government prosecutors present an insider trading case against Rajaratnam and several other executives for illegally profiting from trading stocks and options of Hilton, Google, Akamai and others.

Read more…

Michael Markov Hedge Funds, Main

Back in 2007, we published a research report “The Law of Large Numbers“ with an analysis of the Renaissance Technologies RIEF fund and showed how a similar strategy would have performed during previous recessions and major market downturns. Thus, it shouldn’t come as a surprise that the RIEF has lost about 17% through April and 8-9% in April alone as it was reported by The Wall Street Journal and various blogs. Read more…

Michael Markov Hedge Funds, Main, Research

Pensions & Investments continues to focus on the issue of increased due diligence and transparency in light of the Madoff affair. Read MPI’s opinion piece, “The similarities between Pearl Harbor and Bernie Madoff” which is featured in this week’s P&I Views section. The article provides an interesting link between algorithms used in modern radars and advanced returns-based hedge fund analysis tools.

Michael Markov Hedge Funds

I thought the chart below may be of interest. We compared performance results of Stanford’s investors taken from the SEC complaint¹ with one of the largest stable value funds (name withheld). Stanford results in the complaint go only through 2006 and that’s why the line stops there while the stable value fund continues its upward trend through 2008.

Read more…

1. Please see my previous blog post [↩]

Michael Markov Hedge Funds, Main, Research

On February 17th, 2009 the SEC charged Stanford International Bank (SIB), R. Allen Stanford, et al with “a massive ongoing fraud.” Below are comments regarding potential challenges to SEC’s rationale and approach in supporting their case presented in the complaint on SEC website.

As shown in the excerpt below, the SEC points to SIB’s absolute performance vs. market indexes:

“Double-digit returns… over the past 15 years” which refers to the chart in Par. 28 of the complaint. Note that these are gross returns, while net returns paid to investors were about 8%. Many hedge funds generated higher after fees returns in 1992-2006. Plus, Stanford returns were high three and five years ago, so there must be something else.

Very suspicious performance in 2008: the fund lost “only” 1.3%. Guess what? So did a quarter of all hedge funds. According to the latest HFR data, 1318 hedge funds out of 5313 reporting lost less than Stanford in 2008. And so did about 12% of mutual funds (excluding money market).

Par. 4 of the complaint states that for SIB producing the same returns of 15.71% for two consecutive years 1995 and 1996 was “impossible” to achieve if Stanford have managed a “global diversified” portfolio of investments. Here’s the exact quote from the complaint:

So when did identical returns for two consecutive years become a red flag? This seems more a sign of transparent reporting. If someone were to concoct a fraud, the first thing they would do is to change at least one decimal to make it less suspicious! And by the way, what should be considered a red flag–is 1bp difference sufficient? How about 5bp difference?

First we should note that it is statistically “probable” and “possible” to obtain the same investment return for two consecutive years even when one is invested in liquid market instruments. Highly diversified portfolios would increase the probability. Diversification reduces volatility overall and aggregating volatile data into annual returns further reduces volatility. In addition, if underlying assets have similar performance during these years it increases the likelihood of the portfolio achieving similar results.

We ran a quick test and found about two dozen mutual funds and hedge funds having 1995 and 1996 returns within 10bp range. Note that these are only survivors and the number of actual funds that existed at that time could be easily 2-3 times higher. There are some identical matches in consecutive year performance and for many funds 1995-96 results are within 2-3 bp range.

So is it really a red flag? Well, not by itself based on the above considerations. Whether these numbers represent real returns and are not made up requires more sophisticated analysis such as returns-based (RBSA) and other quantitative due diligence methods.

Michael Markov Hedge Funds, Main