Hedge funds have been attacked on many grounds - too expensive, too secretive, too unreliable, too hard to understand. Yet nobody to our knowledge has criticised them on the grounds that what hedge funds do can be cheaply replicated by a computer.

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Yet that is in essence is the accusation made by the UK's leading academic specialist on derivatives and alternative investments in an updated version of a paper released this week. Professor Harry Kat, of the CassBusinessSchool in the City of London, entitles his provocative paper "Who needs hedge funds?"  The question, reading his analysis, certainly deserves an answer.
 
Rising from relative obscurity, points out Professor Kat, over the last 15 years hedge funds have become increasingly popular with both high net worth individuals and institutional investors. The number of hedge funds has risen from around 500 in 1990 to an estimated 8000 in 2005. Assets under hedge fund management have risen over the same period from $50 billion to $1 trillion.
 
More recently it has been the fund of funds concept that has driven the rapid growth of hedge funds. Most money that flows into the sector now comes in the shape of funds of funds investment. The total number of such funds is now estimated to be around 4000, or half the total. Typically a fund of funds adds a further layer of fees, typically 1% per annum plus a 10% profit share, to the cost of the underlying fund.
 
The marketing story behind the hedge fund revolution has subtly changed over the years, however. "Initially" says Prof Kat "hedge funds were sold on the promise of superior performance, the story being that hedge fund manager's long experience and proven investment skills were a virtual guarantee for superior returns". High net worth individuals proved particularly susceptible to this kind of argument in the early growth phase of the industry.
 
But towards the end of the 1990s, the story began to change. In Prof Kat's words: "No longer were hedge funds sold on the promise of superior performance, but more and more on the basis of a diversification argument, pointing at hedge fund's relatively low correlation with stocks and bonds and the beneficial effects on risk and return from including hedge funds in the traditional investment portfolio".
 
He identifies two reasons for this change in sales tactics.  One was the awkward fact that, starting in the late 1990s, hedge fund performance began to take a turn for the worse, with each succeeding year producing less impressive results than the one before.  In keeping with this trend, according to the HFRI Fund of Funds Composite Index, the average fund of funds returned a meagre 3.85% in the first ten months of 2005.
 
The second reason for this change in tack has been the evolving nature of the demand for fund of hedge funds. Disconcerted by historically low interest rates, and substantial losses from the equity markets, institutional investors have begun to look more seriously at hedge funds as an asset class. As institutions, unlike high net worth individuals, place much greater emphasis on risk management, the hedge fund story has inevitably changed to accommodate its new clientele.  
 
Now of course, the big drive is to make hedge funds attractive to the retail investor (always the last, one might comment, to be asked to buy into a maturing investment class). Fund of funds are once more the chosen vehicle.  How much simpler, though, if the same combination of risks and returns offered by the best funds of hedge funds could be created by other means? The encouraging answer, says Prof Kat, is that by and large they can.
 
The demonstration of this proposition runs to some 40 pages of graphs and equations in Prof Kat's paper, so it cannot easily be replicated here. Suffice it to say that he and his co-author, Helder Palaro, use a returns-based approach to create model portfolios that closely mimic the risk and return characteristics of specific, real world hedge funds (up to and including such statistical properties as skewed tail distributions and kurtosis).
 
Needless to say, as with all such academic approaches. the model portfolios produced by this means are only as good as the assumptions that go into them. Two in particular appear crucial to Prof Kat's argument. And given the uncertainties in all financial markets, there is no guarantee of course that a model that has worked well in the past will work as well when applied in future (a design flaw that eventually was to prove the undoing of the rocket scientists at Long Term Capital Management).
 
Yet with the hedge fund industry implicitly admitting, says Prof Kat, that "hedge fund performance is no longer truly superior", he is surely right to say that there may be commercial potential in developing models that can provide the risk/reward profile of a successful fund at a fraction of the cost of the real world alternative. It would, above all, offer a simpler, cheaper and more transparent solution to that of the average hedge fund, to the satisfaction of regulators and investors alike.
 
As it is, says Prof Kat, hedge fund managers typically go to great efforts to cast a veil over precisely where and how their returns are generated.  The other drawbacks of the traditional hedge fund approach include the need for extensive due diligence work and a serious lack of liquidity. Most hedge funds have "lock-up" structures that tie in new investors for periods ranging from six months to five years, as well as an exit notice period of up to three months. To add salt into the wound, some funds also charge an exit fee as well. 
 
It would be entirely in keeping with financial history, one has to observe, if hedge funds were soon to go ex-growth. It is the inevitable consequence of new money flooding into any sector at such a rapid pace. Is that point now nearing? There is certainly some evidence that in certain sectors, such as convertible arbitrage, performance is continuing to suffer from strategy overkill. According to the Financial Times, there may even have been a net outflow of funds from the hedge fund sector in the third quarter of this year. It would be ironic of course if hedge funds, whose returns look relatively anaemic now after three strong years of stock market recovery, were to lose favour just as stock markets were about to turn down once more, as seems possible in 2006.
 
One of the funds at stock market favourite RAB Capital is meanwhile reported to have lost 8% in October alone, a startling result for a type of fund allegedly dedicated to the pursuit of absolute returns. Shares in RAB Capital have underperformed the market by 15% in the last three months. The growing academic challenge to the validity of the arguments that have been used to sell hedge funds until now, of which Prof Kat’s offering is just the latest example,  is a further symptom of a broader truth about the maturing (and inevitable waning appeal) of hedge funds as an investment class.

Jonathan Davis
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