Report Suggests Grouping Hedge Funds by Return Behavior

October 22, 2007 ( - A report from The Bank of New York Mellon and independent research firm Oxford Metrica suggests hedge funds be classified according to the observed behavior in their returns rather than management style.

According to a news release, the firms’ research indicates the convergence between hedge fund and equity market returns, combined with inconsistencies in hedge fund classification, could cause widespread confusion on how hedge funds should be used to diversify investment portfolios and result in unrealistic return expectations for investors. Many hedge funds may change their strategy to maximize alpha and the resulting style drift is the cause of much difficulty in benchmarking and investor understanding, the news release said.

In classifying 5,282 hedge funds, the study found:

  • 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 lackluster – funds that drift from one cluster to another tend to underperform.

The analysis also showed most categories of style and strategy, on average, are less volatile than the equity markets.

“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,” David Aldrich, managing director, The Bank of New York Mellon, in the news release.