A new hedge fund classification system would help the hedge fund industry achieve transparency and boost investor confidence, according to a study conducted by The Bank of New York Mellon and independent research firm Oxford Metrica.
In lieu of the collapse of Amaranth and other factors, hedge funds are increasingly challenged to present transparency. Without hedge fund managers entirely giving away their secrets, BNY Mellon presents cluster analysis as a way of demonstrating more transparency, and was motivated to find a best practice.
The results of the study, titled “Rethinking performance in the hedge fund industry,” were unveiled at a press conference this morning, recommending that cluster analysis be used to classify hedge funds. In the traditional classification, there are 11,000 categories. Cluster analysis groups funds according to the observed behaviour in their returns, as opposed to management styles.
“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,” says Rory Knight, principal of Oxford Metrica. “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.”
Key finds of the report include that stable clusters perform better. A stable cluster provides a more consistent performance, says David Aldrich, managing director, BNY Mellon. He also says that in the report outliers can do well or very poorly. Amaranth, for instance, was an outlier, but Aldrich points out that the best performing hedge funds have a significant number of outliers. On the other hand, drifters, or funds that drift from one cluster to another, tend to underperform.
“It’s fair to say that only half of the hedge funds out there make it into a stable cluster,” Knight says. A
The study claims to dispel some common myths around hedge funds, including that all hedge fund returns exhibit high volatility. The study says that hedge funds are less volatile than equity markets. “We believe it’s not a good label to apply to hedge funds,” Aldrich says.
Also, while a common myth assumes that hedge funds generate pure Alpha, the study says hedge fund returns are increasingly systematic or beta driven. A third myth that all hedge funds contribute little marginal risk to a core equity portfolio, is also disproved. The study says that as hedge fund and equity returns converge, these vehicles are less effective as diversification media.
“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,” Aldrich says. 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.”