Responding To Convergence: Counting The Greeks

Apr 5 2007 | 12:04pm ET

Much has changed for hedge funds since the early 1990’s, but superior performance remains the primary driver of survival.

Survival alone, however, does not put bread on the fund manager’s table, and with 2007 shaping up to be another banner year for fund proliferation, four changes to our traditional perceptions are worth noting:

1. Performance is converging among retail, high net-worth and institutional funds. Minimum investment level is no longer a signal of structural sophistication for a fund class.

2. Fee structures are diverging by fund class. Increasingly, management fees are growing for retail funds and declining for high net-worth and institutional funds. Performance fees have been stable.

3. Institutional funds tend to be first movers with product innovation while retail funds lag behind.

4. As the competition for alpha grows, seemingly rosy fund returns may carry a far-from-silver lining. Attention to risk management is growing in importance.

Last week, Brian Hunter’s re-emergence in the media reminded us yet again that mean and standard deviation are not the only statistics that matter. In fact, gamma (skewness) and theta (kurtosis) are critical metrics for assessing the risk level of a fund.  Gamma measures the skew of the distribution of returns: Positive gamma indicates a higher probability of positive returns, but does not guarantee a positive outcome every single time. Theta measures the likelihood of extreme events, such as rare market conditions leading to windfalls, as well as those Hunter blamed for the collapse of Amaranth Advisors. The higher the theta, the higher the chance of both extreme positive and negative returns occurring. In short, for the best and safest portfolio performance, we want high gamma and low theta.

Figures 1 and 2 show the evolution of gamma and theta for different categories of funds over time. The Standard & Poor’s 500 has negative gamma and almost non-existent theta over the past decade. A convergence, of sorts, is observed between the gamma and theta of institutional and retail funds, continuing the overarching trend in the mean-variance space.  

A disturbing observation is that the theta of high net-worth funds has skyrocketed lately to the levels unseen even by the institutional funds of the early ‘90s.  And while high net-worth investors may feel good about reaping the relatively high gamma, unprecedented levels of theta and the least likely events it represents are bound to effect high-theta funds at some future point.

Please feel free to contact the authors at insights@finalternatives.com.

by Irene E. Aldridge and Steven F. Krawciw


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