Report spotlights common myths regarding hedge fund volatility, alpha- generation and risk

LONDON, October 22, 2007 — The convergence between hedge fund and equity market returns, combined with inconsistencies in hedge fund classification, could cause widespread confusion on how such funds should be used to diversify investment portfolios and result in unrealistic return expectations for investors, according to a study conducted by The Bank of New York Mellon and independent research firm Oxford Metrica.

The report, entitled Rethinking performance in the hedge fund industry, 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.

Traditional hedge fund indices are challenged by increasing demands to demonstrate transparency of the underlying funds and many hedge funds may change their strategy to maximise alpha. The resulting style drift is the cause of much difficulty in benchmarking and investor understanding.

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

  -- 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 lack-lustre - funds that drift from one cluster to another
     tend to underperform

David Aldrich, managing director, The Bank of New York Mellon, said: "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."

Dr. Rory Knight, principal of Oxford Metrica, said: "Cluster analysis adds a time dimension to the classification of hedge funds and thereby allows a robust means of evaluating any drift in style over time. 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."

  The study removes three common myths surrounding hedge funds:

  -- Hedge Fund Myth #1: All hedge fund returns exhibit high volatility.
     The analysis reported shows that most categories of style and
     strategy, on average, are less volatile than the equity markets.
  -- Hedge Fund Myth #2: All hedge funds generate pure Alpha.
     Despite the ubiquity of the "absolute return" epithet in the industry,
     hedge fund returns are increasingly systematic or beta driven.
  -- Hedge Fund Myth #3: All hedge funds contribute little marginal risk to
     a core equity portfolio.
     As hedge fund and equity returns converge these vehicles are less
     effective diversification media.

This paper is the fourth is a series of thought leadership papers published by The Bank of New York Mellon addressing key issues facing the alternative investment management industry, including "Institutional Demand for Hedge Funds" and "Hedge Fund Operational Risk: meeting the demand for higher transparency and best practice".

The Bank of New York Mellon
The Bank of New York Mellon Corporation is a global financial services company focused on helping clients manage and service their financial assets, operating in 37 countries and serving more than 100 markets. The company is a leading provider of financial services for institutions, corporations and high-net-worth individuals, providing superior asset management and wealth management, asset servicing, issuer services, clearing services and treasury services through a worldwide client-focused team. It has more than $20 trillion in assets under custody and administration, more than $1.1 trillion in assets under management and services $11 trillion in outstanding debt. Additional information is available at bnymellon.com.

Oxford Metrica
Oxford Metrica is an independent research and analytics firm in international investments. The firm focuses on risk, value, reputation and governance - the strategic aspects of financial performance. Oxford Metrica aims to provide evidence-based support for key management decisions. Oxford Metrica also provides research and analytics to several hedge fund managers particularly those involving emerging markets and multi-manager strategies. Additional information on the firm is available at http://www.oxfordmetrica.com/.