The Sky Is Falling On Hedge Funds? Not Necessarily

by: Christopher Holt

Last week, media reports trumpeted that investors removed $3.5bn from equity market neutral hedge funds in September (see data).

This makes perfect sense, really. According to one report it was because some of them “made losses of more than 30% during the previous month, even though they are intended to move independently of the stock markets.”

But it’s often the stories that “make perfect sense” that subsequently go unchallenged and unquestioned. So we thought a sober second thought might be in order…

a) While it’s true that a few high profile funds (out of 9,000) were down big time, the HFRI Hedge Fund Composite Index, a broad measure of hedge fund performance was down only 1.5% - a far cry from “more than 30%“.

b) The S&P 500 was actually up in August, not down. So it’s not clear what this report means by “moving independently of the stock markets“. But even if both the market and the HFRI were down a lot in August, that still wouldn’t say anything about the correlation between the two. After all, two uncorrelated coins flipped together could both end up heads at the same time. Would that mean they are actually correlated after all? (see related posting)

c) But the element that really gives us pause is this: the source of the asset outflow data, database company Barclayhedge, made the same sort of pronouncement last month (about August’s asset numbers) - only to recant a few days later when the firm realized assets had actually grown in July, not shrunk.

In fairness, last month was the first time this particular study had been undertaken. And this new data may well be totally accurate this time, but it underscores the danger of rushing to conclusion regarding hedge fund data - especially when that conclusion is so easy to believe.

The data making its way into these studies is provided by hedge fund managers on a voluntary basis, and as this report suggests some managers may even “misrepresent returns”. But even so, some are very willing to overlook this weakness:

Hedge funds are loosely regulated portfolios that are not required to disclose their returns or asset flows to industry groups or regulators, so the data, when reported on a voluntary basis, is often reviewed closely for investment trends.

Therein lies the danger with rushing to conclusions based on hedge fund databases. Their voluntary nature is precisely why they should not be reviewed too closely for investment trends.