From the October 2004 issue of Investment Advisor • Subscribe!

Are Hedge Funds Worth It?

In a rebounding stock market, hedge funds may not be the first to benefit, but in the long run they are certainly worthwhile, according to research conducted by Citigroup Alternative Investments.

Citigroup predicts that hedge fund returns will decline to an average of 10.1% annually going forward. Moreover, of the 12 main hedge fund strategies, 11 are experiencing a significant reduction in the level of alpha generated by managers. "I think you see the industry maturing a bit, and you are seeing investors taking a second-generation look at hedge funds," says Neil Brown, managing director and global head of product and client services at Citigroup Alternative Investments.

Part of that second-generation look is studying the risk-adjusted returns of hedge funds. When Citigroup took a closer look at returns across the various hedge fund strategies, it found that between 24% and 93% of the variation in hedge fund performance could be explained through a fund's exposure to traditional market-related factors.

Citigroup's research team dissected the average annual returns of 12 hedge fund strategies from 1990 to 2002 using data from Chicago-based consultant HFR. What they found was that hedge funds still had attractive returns relative to the risk taken in their portfolios compared to traditional equity and fixed-income markets, even though they may not have posted the same stellar performance of years past. The researchers also discovered that certain hedge fund strategies might not be as uncorrelated to traditional investing as most investors believe. On average, 55% of hedge fund returns can be attributed to movements within the traditional equity and bond markets. Still, those market effects depend on the hedge fund's strategy.

Using a simple factor model analysis, equity hedge funds unsurprisingly seem to bear the full brunt of traditional market volatility. According to Citigroup, 93% of the return variance of equity non-hedge strategies could be explained by specific market factors. Bond strategies fared better; only 24% of the performance moves among fixed-income arbitrage managers came from long-only market factors.

"We believe that using a broader set of correlation factors paints a truer picture of how much of a hedge fund's performance is related to the manager's skill (alpha) and how much is related to external, market-related factors," the researchers wrote.

Citigroup Alternative Investments was established in 2001 and now manages $75 billion in hedge fund, fund of funds, real estate, and private equity portfolios. The investment unit is focused on "thinking more carefully" about how to include hedge funds in traditional investment portfolios, says Brown. Research findings help portfolio managers come up with portfolio construction techniques, tools for stress testing, and better overall risk management.

In upcoming months, the research group is slated to outline a specific methodology for constructing portfolios with uncertain performance forecasts. For hedge funds, alpha is declining, but Citigroup re-searchers are hard pressed to tell investors whether that trend will continue. The consensus among industry watchers is that hedge funds will continue to have a wide dispersion of returns.

Still, even the riskiest of hedge funds will not carry the same amount of risk found in the equity market. Citigroup researchers concluded that such dependability should allow hedge funds to remain attractive as they continue to mature.br>

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Susan L. Barreto is a senior reporter for HedgeWorld.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

For further inquiries about HedgeWorld, e-mail inquiry@hedgeworld.com.

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