Hedge fund classification - Simpler may be better

All hedge fund strategies are not created equal. Correct hedge fund classification is important. Poor classification will generate false conclusions on the skill of the manager and may deliver return streams that are unexpected. Asset allocation becomes more difficult if classification is ineffective.

Surprisingly, a quantitative approach to classification will generate different results than the schemes developed by different hedge fund reporting firms. Even when managers are asked to classify themselves they may not cluster with other managers within that style category. One might really scratch his head wondering why neither reporting services nor managers seem to be able to appropriately classify hedge funds, but that discussion could be for another post.

New research in the Journal of Alternative Investments (Classifying Single-Manager Hedge Funds: Some New Insights by Bohhlandt, Smit, and Krige) sheds some light on the classification problem. The researchers are able to condense hedge funds into a much smaller set of style categories through the use of principal axis and factor rotation methods. They find that there are nine major hedge fund classifications. First, there is a simple breakdown between directional and non-directional or market neutral managers.  The market neutral managers can be divided between event driven and relative value. For the directional hedge funds, there is a further breakdown between macro and equity directional hedge funds. The macro grouping includes macro systems, emerging markets, and CTA's. The equity directional strategies include long-short equity, growth, value, and sector focus managers.

Each of these style classifications is related to some well-defined factor exposures. Nevertheless, many hedge funds may be niche players who cannot be clustered through the techniques in this paper. Still, breaking up the world into a smaller number of style buckets may be extremely helpful for thinking about hedge fund behavior and value-added. Simple common factors can be a useful way of describing hedge fund risks. 

The limited set of styles should clarify the thinking of investors when they have to make asset allocation decisions. Think of a three-step process or set of questions. One, do you want directional or market neutral exposure? Two, if you want directional exposure, do you want some variation on equity factors or do you want some macro exposures that have broader appeal to a wider set of asset classes or trends? Three, do you want managers who cannot be easily classified by any set of factors? Answer these three broad questions and you can make the hedge fund allocation decision process easier.