| Fund-of-hedge-funds after fee alpha under fire |
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| 08/07/2007 | |
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Are fund of hedge funds true diversifiers? Not according to Harry Kat, professor of Risk Management at the Cass Business School in London. Kat, formerly a futures trader and economist, has turned his attention to hedge fund performance in recent years. In a number of studies he has refuted the widely accepted notion that hedge funds tend to provide more diversification and alpha than their more plain-vanilla counterparts. "At conferences, I tend to make the point that highly diversified portfolios of hedge funds tend to be highly correlated with the stock market and therefore do not make good diversifiers," he says. "When doing so, fund of funds salesmen rush to the microphone to point out that funds-of-hedge-funds did not go down during the 2000-2003 equity bear market and that such protection alone is worth paying 3+30." Kat points out that it only takes six years of paying fund-of-funds fees to lose the equivalent of a 40% drop in the S&P 500. But even barring that alarming fact, his research shows that multi-strategy hedge fund replicators offered by Merrill Lynch, Goldman Sachs, Partners Group and others actually track the S&P 500 index quite closely. The one exception is the equity bear market of 2000-2003 during which the S&P lost 43% and the HFRI Fund of Funds index was more or less flat. "The HFRI index seems to go up when the S&P 500 goes up, so why did it not go down when the S&P 500 came down during 2000-2003?" When the equity bull market ended in 2000, hedge funds trimmed their equity holdings, subsequently restoring their exposure when the stock market picked up again in 2003. The results of an annual regression of HFRI index returns on S&P 500 returns show a clear beta de-correlation: from .36 in 1999 to .005 in 2002. By 2006 the correlation had risen to .60. "The correlation between the HFRI index and the S&P 500 has been remarkably stable over time," says Kat. "The only two years when it dips significantly below its normal level of around .70 are 2000 and 2002. This leaves one question: are hedge funds' withdrawal in 2000 and their move back into equities in 2003 genuine indications of skill. "I don't think the answer to be affirmative." In August 2000, after seeing the S&P go up by 133% in only 4 years, many investors felt the market was ripe for a correction. Likewise, in February 2003, after a 45% drop in two and a half years, investors were prepared to increase their equity exposure. "Put differently, it does not seem to have required special skills to be bearish in 2000 and bullish in 2003… hedge funds did what many investors thought of doing." Even in the case of out-performance, the fees fund-of-hedge-funds charge often shrink their returns. In a study published in the Journal of Financial and Quantitative Analysis, Kat and co-author Gaurav Amin, an analyst at Schroder Investment Management, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns of a market benchmark with a similar risk profile. Seventy-two of the funds (more than 90%) failed to outperform their benchmarks. In another study (a working paper), Kat and Helder Palaro examined the returns of more than 1,900 funds. The results showed that only eighteen percent of the funds outperformed their benchmarks, and that returns even at the best funds declined over time. "Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative." VB |
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