Study Shows Hedge Fund Returns To Be Unpredictable

by Carla Johnson, Investors Offshore, London

03 June 2002

Any investor in funds wants to know about their past performance before choosing where to invest - it seems intuitively obvious that a fund which has performed well in the past is also likely to do well in the future. But opinions are very divided on this subject. Britain's Financial Services Authority has talked about banning the use of past performance figures in funds' advertising, apparently believing that the past is no guide to the future.

Now a researcher at Reading University in the UK, which has specialised in fund research, has produced a report showing that individual hedge funds cannot be relied upon to show consistency in their annual returns, although they do handle risk in a consistent way.

Harry Kat, a lecturer of finance at Reading, finds "little evidence of persistence in mean returns" among hedge funds, although he finds strong persistence in hedge funds' standard deviations - a standard measure of the volatility of their returns - and their correlation to the stock market.

Mr Kat explains that a fund's track record does allow a prediction about the relative riskiness of a fund in relation to other funds following the same strategy, but does not it does not allow investors to predict an absolute level of risk.

Conclusions of this type are valuable for individual investors, of course, but they are of greatest importance for funds of funds managers, who use historical performance as a basis for picking which funds to include.

Mr Kat does say that there is no agreement among researchers about the predictability of hedge fund returns, and his report lists a number of academic studies which have come to varying conclusions over the last ten years. He says that these past studies may have been flawed because they didn't distinguish between absolute return and volatility.

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