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Bank calls for cluster analysis of hedge funds

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Nicole Blackmore
The convergence between hedge fund and equity market returns could cause confusion on how such funds should be used to diversify investment portfolios, says the Bank of New York Mellon.

A study conducted by the bank and research firm Oxford Metrica shows that combined with inconsistencies in hedge fund classification, the confusion could result in unrealistic return expectations for investors.

The report recommends that hedge funds be classified using cluster analysis instead of the traditional classification by strategy. Cluster analysis groups funds according to the observed behaviour in their returns, as opposed to management styles.

The Bank of New York Mellon managing director David Aldrich says the recent volatility in the equity markets was a real stress test for the hedge fund industry.

He says: “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.”

Oxford Metrica principal Dr. Rory Knight says cluster analysis adds a time dimension to the classification of hedge funds, allowing a robust means of evaluating a drift in style over time.

He says: “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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