Strategy Drift at a Market-Neutral Hedge Fund
Northbridge Capital runs a $1.2 billion hedge fund marketed as equity market-neutral. Its 3-year track record shows 10.8% annualized return, 6.0% volatility, and a Sharpe ratio of 1.8. The fund reports historical correlation to the S&P 500 of 0.10. In the last 12 months, correlation rose to 0.65 and the fund had a -7.5% month. The manager increased 'special situations' from 10% to 35% of risk and now holds 40% of gross exposure in five positions. Average holding period fell from 45 days to 15 days. Prime-broker financing is 6x gross, and redemption terms are 10% quarterly with a 3-year lock. Fees are 2% management and 20% incentive with a high-water mark. The fund's DD report says the strategy is unchanged.
1. What evidence suggests strategy drift, and why does it matter for the fund's risk profile?
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The evidence is the shift of 25 percentage points of risk into special situations, the rise in top-five concentration to 40% of gross, the shortening of holding period from 45 to 15 days, and the correlation to the S&P 500 rising from 0.10 to 0.65. A market-neutral fund should have low net directional exposure and diversified idiosyncratic risk. The new profile looks more like a concentrated, shorter-horizon event/directional strategy. The -7.5% month is a symptom: the fund's stated 6% annualized volatility is not consistent with that loss if returns were truly market-neutral. Risk matters because the investor is paying market-neutral fees and accepting a 3-year lock for a return stream that may now behave like equity beta. The DD report's statement that the strategy is unchanged is no longer reliable and should trigger a re-underwriting.
2. Given the 10% quarterly redemption and 3-year lock, what should an existing LP do?
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The LP should not rely on the headline Sharpe ratio. It should request position-level transparency, net and gross exposure, factor exposures, liquidity of the top five positions, prime-broker terms, and an explanation of the special-situations mandate change. If the manager cannot show that the strategy is consistent with the LP's mandate, the LP should consider redeeming at the next available quarterly window, but the 3-year lock may limit immediate exit. The LP should also assess whether the 10% quarterly gate creates a first-mover advantage and whether side letters or fund-level leverage can impair remaining investors. A reasonable judgment is to place the manager on watch, stop new allocations, negotiate information rights, and redeem if the drift is confirmed and the lock permits. Staying solely because of the 1.8 Sharpe ratio would be anchoring on stale data.