Traditional hedge fund indices are challenged by increasing demands to demonstrate 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 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
- 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 which went wrong
- Drifters are lack-lustre - funds that drift from one cluster to another tend to underperform
David Aldrich, managing director, The Bank of New York Mellon, said: "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. 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."
Dr. Rory Knight, principal of Oxford Metrica, said: "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 study removes three common myths surrounding hedge funds:
- Hedge Fund Myth 1: All hedge fund returns exhibit high volatility. The analysis reported shows that most categories of style and strategy, on average, are less volatile than the equity markets.
- Hedge Fund Myth 2: 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.
- Hedge Fund Myth 3: All hedge funds contribute little marginal risk to a core equity portfolio. As hedge fund and equity returns converge these vehicles are less effective diversification media.
This paper is the fourth is a series of thought leadership papers published by The Bank of New York Mellon addressing key issues facing the alternative investment management industry, including "Institutional Demand for Hedge Funds" and "Hedge Fund Operational Risk: meeting the demand for higher transparency and best practice".
