HEDGE FUNDS VERSUS COMMON SENSE: AN ILLUSTRATION OF THE DANGERS OF MECHANICAL INVESTMENT DECISION MAKING
Harry M. Kat
Kat gives us a piquant illustration of the “GIGO Principle,” or garbage in – garbage out, applied to hedge fund investments, where inappropriate use of the tools of portfolio analysis, such as the Sharpe Ratio, can lead to misleading and costly decisions.
He first explains why hedge fund returns data are fundamentally different from data on stocks and bonds, embedding various biases in their reported returns and volatility. A significant research effort over the last several years has focused on identification and quantification of these data biases found in individual hedge fund returns and in hedge fund index returns.
Looking at the properties of hedge fund return data, Kat points out departures from Normality in the distribution of reported hedge fund returns are the norm, not the exception.
Hedge fund returns exhibit significant negative skewness and excess kurtosis, which are both “bads” to a risk-averse investor. He goes on to show that these “bads” can be correlated with the mean and standard deviation of returns, such that apparently more attractive returns can also carry penalties in terms of skewness and kurtosis.
Kat goes on to argue (compellingly) that, in light of data biases and departures from Normality, the usual application of the standard tools of portfolio analysis, such as the Sharpe Ratio and mean-variance portfolio optimization, does not properly account for these “bads”.
As a result, the mechanical application of these tools can yield incorrect conclusions about the attractiveness of hedge fund investments. Some portion of the apparent “excess” returns earned by hedge fund managers according to standard measurements is not “excess” at all, but in reality is just compensation for taking on the risks that result in observed negative skewness and kurtosis. He states that new tools need to be developed to account for these complexities in evaluating hedge funds.
In the end, Kat issues a challenge to hedge fund investors to use common sense and develop a deep, if qualitative, understanding of hedge funds as part of their asset allocation regimen. Sometimes the best advice is the simplest advice too.
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- Amin, G. and H. Kat, 2003, "Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias 1994 – 2001", Journal of Alternative Investments, Summer, pp. 57-73.
- Brooks, C. and H. Kat, 2002, "The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors", Journal of Alternative Investments, Fall, pp. 26-44.
- Posthuma, N. and P. Van der Sluis, 2003, "A Reality Check on Hedge Fund Returns", Working Paper ABP Investments.
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ERRATA AND OTHER MATERIAL
- Other research by Harry Kat:
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