Strategic Insights: Responding To Convergence

Mar 9 2007 | 12:26pm ET

By Irene E. Aldridge and Steven F. Krawciw -- Fund performance and investment styles are converging.  How can fund executives win in this new environment?

With this series “Responding to Convergence,” we launch a five-week investigation into the changing hedge fund landscape, complete with quantitative observations of fund performance and reviews of various strategies funds are using to make money.

We begin with an exploration of a minimum investment-based fund typology and document convergence of performance among different types of funds. Next week, we will delve into the portfolio holdings of these groups of funds.

Convergence observed

Hedge funds are commonly divded into three “classes” categorized by their minimum investment requirements. This distinction reflects differences in both the financial profile of the typical investor in each fund class and the distribution channels each class of funds uses to reach its investors.   Given the differences across fund classes, strategies and opportunities, each fund class should be considered separately.

We define retail funds as those a minimum investment requirement of less than US$100,000, high net-worth funds as those with a minimum investment requirement ranging from US$100,000 to US$999,999, and institutional funds as those with a minimum investment requirement of at least US$1,000,00. The minimum investment level reflects the ability of investors to access the funds.These broad classes naturally contain a continuum of strong and weak performers. But the trends in per-group return metrics paint an interesting picture.

Figure 1, for example, shows the returns of funds over five-year periods. In the early 1990’s, the funds requiring the largest investments (institutional funds) significantly outperformed other fund categories. Retail funds were earned a respectable 11%-12% annually but were dominated by high net-worth funds, institutional funds and even the Standard & Poor’s 500 itself.

From 1996 through 2000, the performance of high net-worth funds improved while that of institutional funds declined marginally. Interestingly, during this period, both of these groups performed as well as the S&P500, while retail funds continued to underperform the broader markets.

Since 2000, the hedge fund industry has undergone a rapid transformation. The most striking change is that while hedge funds as a whole now outperform the market, there is little discrepancy in returns among the retail, high net-worth and institutional categories.

While the funds have experienced a clear convergence in absolute returns, the comparison of absolute returns alone does not present a statistically viable metric.  What about standard deviations? 

As Figure 2 shows, standard deviations of returns have converged as well over the last 15 years. There is, therefore, little surprise to find Sharpe ratios also converging (see Figure 3).

As the data clearly shows, the distinction in performance of different fund classes based on their respective minimum investment requirements has blurred. Funds aimed at investors with a minimum investment of less than US$100,000 once lagged far behind funds with a minimum investment of more than $1 million in terms of both return and Sharpe ratios. Over the past 10 years, however, the funds requiring smaller investments have made great strides catching up to the big boys performance-wise.

The obvious implication is that it is becoming harder and harder to generate positive abnormal returns, and, as a consequence of this maturation, consolidation, operational excellence and marketing will play ever increasing role.

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    One of the most unique charity benefits in the hedge fund industry, A Leg To Stand On's (ALTSO's) Hedge Fund Rocktoberfest - NYC, raised nearly $500,000 last Thursday thanks to the generous support of major sponsors and nearly 1,400 attendees from the Tri-State finance, business and hedge fund communities. Read more…