HedgeCo.net (New York) – "Attitudes towards hedge fund risk are poised to change," Sara Grillo, Founder of the Coalition for Safer Hedge Funds said in a paper examining proposed improvements in risk measurement, "The evolution will have positive results for the industry."

The paper also analyses the consequences of risk on portfolio performance, the report predicts that regulatory scrutiny will be the catalyst that forces risk levels down and ultimately drives the industry toward a period of maturity. Within this more stable environment, inflows from retail and institutional investors will surge, leading to the emergence of hedge funds as a more popular investment choice amongst the investing public.

Many academics believe that hedge fund returns are not predictable, and that the only persistent factor in performance history is risk itself. Research conducted by Martin Herzberg and Maim Mozes articulates the notion that less risky funds persistently are more likely to outperform riskier ones in the long term. Riskier managers are likely to take large directional “bets” which may crash when the market trends reverse. Less risky funds base decisions on fundamental skill and are less correlated with markets.

The role of high risk funds, Herzberg and Mozes believe, should be to diversify a portfolio rather than act as the main source of return. Aside from investment style, Herzberg and Mozes cite the other factors that affect returns such as the fund size, growth in assets under management, and length of investment history. They note that funds with shorter track records tend to exhibit higher returns than ones with longer track records. They identify the reasons to be their more experimental style, lack of controls, lack of auditing, and self-selection. Herzberg and Mozes hypothesise that funds with lower levels of assets under management tend to outperform, but this tendency fades as assets increase. Additional assets are placed in cash or must be placed with secondary managers, dragging down alpha.

The show is not over yet, she says. In fact, it is just beginning. As attitudes towards risk evolve, there is still plenty more room for the industry to grow. Although industry scandals have left investors reeling, scepticism will fade as industry regulation will increase transparency.

Increased scrutiny by industry watchdogs will lead to the normalisation of risk and return, which will ultimately decrease the level of hedge fund volatility. As volatility levels normalise, hedge funds will become more popular with retail investors and pension funds.
 
This surge in demand will propel the industry through its lifecycle until it reaches its ultimate maturation level. Regulatory developments and their effect on risk will be the catalyst that leads to the emergence of hedge funds as a prominent investment option amongst the investing public at large.

Sara Grillo earned her B.A. from Harvard University with honors. She is currently enrolled in a M.B.A program at the New York University Stern School of Business. She passed the CFA Level One examination in June 2003, and is a affiliate member of the New York Society of Securities Analysts and the CFA Institute.

Tags: assets-under-management, base decisions, fund risk, fundamental skill, hedge fund, herzberg, institutional-investors, investment choice, investment history, investment-style, mozes, performance history, portfolio performance, regulatory scrutiny, risk funds, risk levels, risk measurement, risky funds, self selection, stable environment

Seeking Alpha – Pop Quiz: Which are more expensive, hedge funds or mutual funds? 

Sounds like a pretty dumb question, right?  Well as regular readers will know, this question is actually central to our views here at AAA.  Over two years ago, we told you about an academic study called “Measuring the True Cost of Active Management by Mutual Funds” by Ross Miller of the State University of New York.  Miller argued that since mutual funds could be largely replicated by low-cost index funds or ETFs, the implicit fee for their active management was significantly higher than the posted expense ratios.  For good reason, the paper was subsequently included in the Q1 2007 edition of the Journal of Investment Management.

The latest to make this argument is Mark Kritzman of Windham Capital.  In his article “Who Charges More: Hedge Funds or Mutual Funds?” (Winter 2008 Journal of Applied Corporate Finance) Kritzman says:

Hedge funds, in principle, hedge out market returns and thereby produce a pure alpha; hence the term “hedge fund.” Alpha, in principle, is uncorrelated with market returns. Mutual funds, by contrast, generate returns that comprise a market component and an alpha component. The returns of mutual funds are typically more than 95% correlated with market returns. Taking these factors into account, it is unclear whether hedge funds or mutual funds are more expensive.

Read Complete Article

Tags: arch-nemesis, commitments, good-managers, investment-style, june-14, warrant