New hedge fund classifications would boost confidence, says Bank of New York Mellon

Date: Tuesday, October 23, 2007
Author: Hedgeweek.com

The convergence between hedge fund and equity market returns, combined with inconsistencies in hedge fund classification, could cause widespread confusion on how such funds should be used to diversify investment portfolios and result in unrealistic return expectations for investors, according to a study conducted by Bank of New York Mellon and independent research firm Oxford Metrica.

The report, entitled Rethinking Performance in the Hedge Fund Industry, recommends that hedge funds be classified using cluster analysis instead of the traditional classification by strategy. Cluster analysis groups funds according to the observed behaviour in their returns, as opposed to management style.

Traditional hedge fund indices are being challenged by increasing pressure to demonstrate the transparency of the underlying funds, and many hedge funds may change their strategy to maximise alpha. The resulting style drift is the cause of much difficulty in benchmarking and an obstacle to investor understanding.

In classifying 5,282 hedge funds, the study found that stable clusters perform better. Some investors may wish to invest only in funds whose performance does not fluctuate greatly, or that represent a larger class of funds.

By contrast, outliers are loners that can do well or very poorly. Some investors will be happy to take the risk of a unique fund, but Amaranth is an example of one that went wrong.
Drifters are likely to lacklustre, the report finds; funds that drift from one cluster to another tend to underperform.

'The recent volatility in the equity markets was a real stress test for the hedge fund industry, and should be seen as a springboard for new industry efforts to increase overall investor confidence and to manage return expectations,' says Bank of New York Mellon managing director David Aldrich.

'Increased transparency of the underlying funds, and the use of cluster analysis for fund classification, will help identify a fund's true investment strategy and highlight any style drift, which collectively will improve investor confidence.'

Oxford Metrica principal Dr Rory Knight says: 'Cluster analysis adds a time dimension to the classification of hedge funds and thereby allows a robust means of evaluating any drift in style over time. A major issue for the industry as a whole is to manage risk, return and correlation - alpha will need to be proven to justify the fee structure.'

The authors of the study say it removes three common myths surrounding hedge funds, starting with the assumption that all hedge fund returns exhibit high volatility. The analysis demonstrates that most categories of style and strategy are on average less volatile than the equity markets.

The report also debunks the idea that all hedge funds generate pure alpha. Despite the ubiquity of the 'absolute return' epithet in the industry, hedge fund returns are increasingly systematic or beta-driven.

Finally, the report cautions that it is dangerous to assume all hedge funds contribute little marginal risk to a core equity portfolio. The authors note that as hedge fund and equity returns converge, these vehicles are less effective as a means of diversification.

The study is the fourth is a series of thought leadership papers published by Bank of New York Mellon addressing key issues facing the alternative investment management industry, including institutional demand for hedge funds and the growing pressure on hedge funds to meet higher standards of transparency and best practice from investors concerned about operational risk.

Oxford Metrica specialises in independent research and analytics firm on international investments, focusing on risk, value, reputation and governance as strategic aspects of financial performance. The firm provides research and analytics to several hedge fund managers, particularly those involved in emerging markets and multimanager strategies.

The Bank of New York Mellon, which operates in 37 countries and serves more than 100 markets, provides financial services to institutions, corporations and high-net-worth individuals including asset management and wealth management, asset servicing, issuer services, clearing services and treasury services. The group has more than USD20trn in assets under custody and administration, more than USD1trn in assets under management and services USD11trn in outstanding debt.