Risk & Compliance

Marching to Different Drummers

Hedge fund managers stick to what they are good at, but that doesn't mean investors should breath a collective sigh of relief.
Joseph McCaffertyJuly 30, 2007

A report by the New York Federal Reserve on hedge
funds set off alarm bells recently when the bank seemed to suggest
that funds were stockpiling too many eggs in one basket.
Headlines based on the paper, by Federal Reserve economist
Tobias Adrian, warned that hedge funds have concentrated
risk in too few places, prompting fears that an economic blip could
lead to a devastating domino effect.

But a careful reading of the report
indicates otherwise. While Adrian did find
that hedge-fund returns are closely correlated,
that is not because funds are following
similar investment strategies but
because volatilities across a spectrum of
investments are currently quite similar.

“Just because returns are correlated
does not mean that the investments
are,” says Peter Morici, a professor at the
University of Maryland. Rather, he says,
“it’s an indication that the markets are
working efficiently and that competition
is keeping returns within a [tight] range.”

Ironically, the recent collapse of
hedge fund Amaranth Investors offers
proof of the overall health of the industry, according to Ed Easterling,
founder of Crestmont Research, which follows the hedgefund
industry. That Amaranth’s loss of more than $3 billion in natural-
gas investments did not hasten a downfall in other funds
indicates that “hedge-fund managers tend to stick to what they
are good at,” says Easterling, and collectively spread risk across
many industries and investment options.

But Morici, for one, argues that closely correlated returns
and a reliance on individual investing strengths still say little
about the overall nature of the unregulated hedge-fund industry.
“From what we know about hedge funds, we should still be skeptical,”
he says. Reports of an impending domino effect may have
been mistaken, but the resulting sigh of relief will likely be brief as
many observers resume holding their breath.