4. Peer Group Analysis

Peer group analysis is the final piece of the basic investment quantitative toolkit. It allows investors to see how a particular fund ranks over various periods compared to funds using the similar investment strategies.

Top Quartile Performance

The fund in Figure 25 ranks in the top quartile of its peers over all of the trailing periods measured. This means that, out of all of the funds that manage money in the same investment strategy, the selected manager ranks in the top 25% of his/her peer group. If we assume an investment universe of 100 funds, this manager would rank within the top 25 funds in terms of recent returns for that investment strategy. You can perform peer group analysis on numerous statistics, including compound annual return, drawdown. Sortino ratio. Sharpe ratio. percent profitable months, etc. Managers who consistently rank high among their peers in a number of statistical categories are generally considered better managers.

Bottom Quartile Performance

Figure 26 shows the same fund measured against its peers based on calendar years instead of recent periods. The fund ranks in the bottom quartile on more than one occasion. This means that, out of all of the funds that manage money in the same investment strategy, the selected manager ranks in the bottom 25% of his/her peer group. If we assume an investment universe of 100 funds, this manager would rank within the bottom 25 funds in terms of calendar year returns for that investment strategy. Although the fund looked good based on trailing periods (Figure 25 ), Figure 26 illustrates that there had been no consistency in top performance over the years

Peer group analysis is important for a number of other reasons. Perhaps its best use is in screening data to find new investment managers. All too often, investors let arbitrary wish lists govern their screens. Seeking a manager with a 3-year track record, no losing months, an annualized return greater than 15%, and a Sharpe ratio greater than 2 does not guarantee that such a manager exists, or if they do exist, that they will be open to new investments. To select the best funds from a quantitative standpoint, it is best to think in terms of percentiles rather than absolutes, and herein lies the value of peer group analysis. Therefore, your goal should be to find the best fund manager comparatively, rather than search for an investment fantasy.

Manager Search Criteria

Assume you are searching for a hedge fund of funds (FOF) and require a MAR of 10%. You can complete the following 5-step process:

Step 1 — The first step is to narrow the investment universe to include only FOFs. Starting with a large hedge fund universe comprised of all strategies we searched for FOFs, narrowing our hedge fund universe from approximately 1,700 funds to about 250 funds.

Step 2 Select the Statistics for Screening: Using your new knowledge of statistics, select realistic statistics to use in your screens. For example, if you’ve developed an investment mandate that dictates you need high returns and are less concerned about drawdowns, you might use the compound annual return, rolling returns, and Sortino ratio (MAR 10%) rather than drawdown statistics. If losses are your paramount concern, you might consider the Sortino (MAR 0%) ratio, drawdown, Sterling and Calmar ratios.

Step 3 Determine the Investment Period: To ensure you compare apples to apples, screen for funds with similar track records. Because the markets experienced a significant stress point in 1998, search for funds that started in or before January 1998. This track record narrows our sample to about 75 funds.

Step 4 Select Funds that Meet the MAR: Next, we search for all funds with an annualized return greater than 10% (our MAR). These actions reduce our universe to 36 funds.

Step 5 Rank the Funds by Percentiles and Assess Sharpe Ratios, Maximum Drawdowns, Sortino Ratios and Correlations: Rather than search all 36 funds for the wish list criteria, we first rank the funds by percentile to determine reasonable search characteristics. Since the required MAR is 10%, we do not rank on annualized return, so we first assess the Sharpe ratio, as the Sharpe measures risk vs. reward and a manager with a strong risk-reward profile is part of our mandate.

Figure 27 shows that a fund must have a Sharpe ratio greater than 1.28 (using a risk free rate of 5%) to be in the top quartile of these funds.

Next, we screen for maximum drawdown, because our particular investment mandate dictates that we want to limit drawdowns, even if it means limiting some upside potential. In Figure 28. we see that to be in the top quartile for maximum drawdown. funds must have lost less than -5.50% during their maximum drawdown.

Then, we focus on the Sortino ratio to ensure we give downside deviation its due without sacrificing any upside that might be generated by a high standard deviation with good returns. As Figure 29 illustrates, to be in the top quartile for the Sortino ratio (MAR of 10%), funds must have a Sortino ratio greater than a 0.69.

We then search our FOFs universe for those funds with a Sharpe ratio greater than 1.28, less than a 5.50% maximum drawdown, and a Sortino ratio greater than 0.69. In other words, we wish to find FOFs with top quartile performance in all criteria categories. As a result, we find 4 funds out of 36 that are quantitatively the cream of the crop, given our criteria and compared with their peers.

Another reason that investors consider FOFs is to diversify their long-only portfolios. So a final step in our quantitative search might be to find FOFs with a negative correlation to the S&P. When applying this criterion, we reduce our list of 4 to 2.

This same 5-step search process can be completed on virtually any universe of funds, including hedge funds, separately managed accounts, commodity trading advisors (CTAs) and mutual funds. Perhaps the most important part of the search process is to first establish reasonable search parameters. Otherwise, you risk setting the bar too high for any fund to hurdle, and backing down from there later. Also, recognize that peer group analysis is still important after an investment is made, since it provides one way to determine if the fund continues to offer the best investment option within a given investment strategy, or if other funds provide better options.