When to Exit Illiquid Investments (Private Equity, Hedge Funds etc.)

Question

I have a question relating to Exiting Hedge Funds and Private Equity investments and was wondering if some of the members of this forum could impart some of their typical wisdom.

For context, in addition to trading some of my own systematic strategies, I invest a proportion of my account in systematic Hedge Funds and Private Equity. I work a full-time job so it’s too much work to invest completely without external help. In addition, I select for funds that have uncorrelated return streams and this provides my overall portfolio with some level of diversification. The funds I invest in have a live track record exceeding 20 years because I value (rightly or wrongly) the ability of a fund to adapt to various regimes/market cycles.

My question is: is there a reasonable way to assess whether I should pull the plug of an underperforming fund? How can I assess when a fund has lost its edge and is no longer a reasonable investment? This question is similar to “when should I stop trading a personal strategy in my personal account?” but it’s a bit trickier due to the nature of hedge funds. Exiting a hedge fund incurs significant fees and exiting can sometimes take 3-6 months. In addition, once I’ve exited a fund, there are significant costs to re-entry should performance revive in the future. I don’t think a reasonable approach would, for example, be “generate a 200dma of the fund performance and enter/exit depending on whether the fund returns are above this ma.” This approach would incur too many fees.

The other consideration that complicates the decision is the “fact” that the forward returns of private equity and systematic hedge funds tends to higher when the fund has incurred a drawdown. In fact, from my research (after trying to account for survivorship bias), I found that the steeper the drawdown, the better the forward performance, on average. Take trend following, as an example, I think forward returns for trend following strategies tend to be better after a period of underperformance. This has led some fund-of-funds to favoring a buy-the-dip approach.

After thinking about this issue, my thoughts on possible solutions are:

1. Don’t be concentrated in any individual fund. Then hold all funds “forever.” This will eliminate onerous entry/exit fees and prevent “selling at the low.” Of course, some funds will go to 0 and the money invested there will be a 100% loss. However, since concentration in any particular fund is low, this should be a survivable situation.

2. Find the maximum Peak-to-Trough drawdown over the entire fund history and exit when current returns dip below some multiple of this drawdown. For example, if maximum historical drawdown is 30%, exit if current drawdown is 45% (1.5x). Never re-enter. This would open up the possibility of selling on the lows. In addition, there are not that many good funds in the world :wink: so this strategy would reduce your selection to “inferior” candidates over time. The benefits of this approach would be to allow greater concentration on funds that you have high conviction on (since max risk would, in theory, be capped) Please let me know your suggestions/comments. Very keen to hear what others think.

Answer 1

If you think putting your money somewhere else will produce better results, of course you should do so.

It's up to you to decide whether and when that is true.

If there was a simple way to determine which funds are going to succeed, everyone would jump on those, and the reduced need for money would also reduce the possible returns from them. You are (potentially) getting more than you would from other investments precisely because you are taking more risk.

Do your homework, make your decisions, accept the tradeoffs, cross your fingers... and don't succumb to the sunk-costs fallacy; focus on what the best thing is to do with your money now rather that thinking you have to wait for the existing investment to recover.