Hedge Fund Returns on the Cheap, Really?

July 6, 2007 |

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We have been acquainted with Dr. Harry Kat (professor of risk management at Sir John Cass Business School, which is part of City University in London) for a number of years. In fact, we use some of his research to justify why investors are well served to take a look at emerging hedge fund managers over their well established colleagues. Recently, Harry Kat was interviewed by The New Yorker about his latest endeavor, a software product designed to generate hedge fund returns mechanically and cheaply. In particular, Kat chose to try and replicate the returns of the Quantum Fund run by George Soros. To quote the article:

“It is possible to design mechanical futures-trading strategies which generate returns with the same, and often better, risk-return properties as hedge funds,” he said. “This means investors can have hedge-fund returns but without the massive fees and all the other drawbacks that come with the real thing.”

One of Kat’s main complaints about hedge funds, or maybe not necessarily a complaint but an observation, is that the 2 and 20 compensation model used by hedge fund managers negates the returns for the investors. Now Kat does not claim his FundCreator product will match Quantum before fees, but it will match or at least come close after fees. To be fair, Kat understands this and makes it clear in the article by stating …

“People say, ‘Look, you don’t generate any alpha.’ After fees, I generate a lot of alpha. I just generate it differently. Instead of trying to beat the market, I get the fees down.” He conceded that there will always be hedge funds whose returns FundCreator can’t hope to match, but he argued that even some of the most prestigious funds owe much of their success to luck. “You can be fortunate,” he said. “You can live off market trends for quite a while. As in credit spreads”—the difference in yields between different types of bonds. “Credit spreads start to come down, and you make lots of money in credit. A couple of guys from an investment bank’s credit desk jump out and start a fund. If they are lucky, the trend continues for another couple of years, and they will look like masters of the universe. But when the trend reverses, or when there is no trend left, they are in trouble. If a guy has done well for two years, what does that mean? He could be really smart, or he could be really lucky. If I had bought stocks at the end of 1997 and you had looked at me at the end of 1999, I would have looked brilliant.”

And of course it is nearly impossible to distinguish between genuine investment skill and random variation. Yet, some firms manage to generate high returns with low volatility.

But the point is whether or not hedge fund managers will be sidelined as computer programs like Fund Creator continue to be tested, developed and marketed? This may threaten some of the more “traditional” hedge fund strategies such as long/short rather than global macro. Or maybe not. In the mean time, we would not worry much about it. We are thinking of contacting Harry Kat to get more perspective on his research and FundCreator product. Stay tuned.

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