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Research Eyes Strong Performance Minus the Fees

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LONDON (–Funds of funds have become the punching bag for many who are inclined to bash hedge funds in general. Often it’s the fees that draw the most criticism. Now some researchers are telling investors how to reproduce top returns of funds of funds without those irksome fees.

Harry M. Kat and Helder P. Palaro also believe their method could help investors that must rely on funds of funds achieve a better way to better evaluate their returns. They say most funds of hedge funds have failed to add value, and investors could trade S&P 500, Treasury bond and Eurodollar futures and produce similar returns.

Last year, Mr. Kat and City University Ph.D. student Mr. Palaro released similar research in which they looked at replicating the strategies of single-strategy hedge funds by using futures strategies. Mr. Kat, a professor of risk management and director of Cass Business School’s Alternative Investment Research Centre, has advocated other improvements on hedge fund investing in the past. While at the University of Reading, he wrote about the use of stock index puts as a buffer against negative hedge fund performance.

In order to measure the alpha that is available to fund of fund investors, Messrs. Kat and Palaro developed a technique that creates a similar distribution of risk and return in a sample portfolio as that of the underlying assets of the fund of funds.

Starting out with a fund of funds’ returns net of fees, officials can make a model of a fund’s distribution of returns along with a model of the investor’s overall portfolio. In an example given in the paper, researchers found that by trading S&P 500, T-bond and Eurodollar futures, investors would have achieved the same risk profile as with a fund of funds and would have had a higher average return at the same time.

According to the researchers, their results were unusual in that most studies say that funds of funds generate superior returns over time. The factor model used in most analysis is crucial because that it can present investors with an incorrect view of performance, they argue. Messrs. Kat and Palaro say that it’s hard to determine whether returns are really alpha or just unexplained because one or more of the risk factors was left out or were specified incorrectly.

“It is quite surprising that so many people, on the buy-side as well as in academia, are so eager to believe that the sometimes huge alphas reported for hedge funds are truly there,” the researchers wrote in their latest working paper, “Replication and Evaluation of Fund of Hedge Funds Returns.”

The “KP measure,” as they have dubbed it, is built relying on the return replicating procedure used by Messrs. Kat and Palaro in previous research. The technique relies on assumptions that are less crucial to the final outcome of the evaluation when compared to other types of methodologies, which may rely on volatility measures or other factors.

The higher the KP measure, the better the fund of fund’s alpha prospects. Still, Messrs. Kat and Palaro say that a high KP measure should be followed up by further due diligence to make sure that a manager has produced returns without taking on any extreme risks.

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Contact Bob Keane with questions or comments at [email protected].


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