Report Debunks Hedge Fund Myths, Calls For New Classifications

Oct 22 2007 | 1:13pm ET

The Bank of New York and research firm Oxford Metrica have gone to some lengths to debunk some popular misconceptions regarding hedge funds.

According to a new report from BoNY and Oxford Metrica, the convergence between hedge fund and equity market returns have laid to rest three popular beliefs about hedge funds. The study found that hedge funds are, on average, less volatile than equity markets and are decreasingly effective as diversification vehicles. And in debunking the myth that “all hedge funds generate pure alpha,” the firms came upon another myth: the concept of alpha itself.

“Despite the ubiquity of the ‘absolute return’ epithet in the industry, hedge fund returns are increasingly systematic or beta-driven,” the report concludes.

The study argues that hedge funds should do away with traditional strategy-based classifications in favor of cluster analysis groupings, which focus on “observed behavior in their returns.” The former, according to BoNY and Oxford Metrica, “could cause widespread confusion” and “result in unrealistic return expectations.”

“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,” BoNY managing director David Aldrich said. “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.”

According to the report, stable clusters actually perform better, while “drifters” that move between clusters tend to underperform.

“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,” Oxford Metrica’s Rory Knight said. “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.”

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