A new survey 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. A study conducted by The Bank of New York Mellon and independent research firm Oxford Metrica finds that 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.

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, it says.

In classifying 5,282 hedge funds, the study found that: stable clusters perform better; outliers are loners that can do well or very poorly; and, funds that drift from one cluster to another tend to underperform

David Aldrich, managing director, The Bank of New York Mellon, stated, “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, added, “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.”