Flying Dutchman Portends Doom for Hedge Fund Industry

The Flying Dutchman is a legendary ghost ship that is believed to be a sign of imminent doom for mariners.  This fact is surely not lost on Dutchman Harry Kat, who today flew into London’s Landmark Hotel and launched a blistering attack on hedge funds at major hedge fund conference – questioning the industry’s very existence.  Kat claims synthetic hedge funds solve several problems with the hedge fund industry including, in his words, annoying managers.  So like the ship, is Professor Kat a harbinger of doom for the hedge fund industry?  Or, is he yet another false prophet – one of many littering the hedge fund annals?

As regular readers will recall, Kat aims to replicate hedge funds – not by matching their returns, but buy matching only the distribution of their returns (conveniently, it turns out the actual returns generated by these cloned distributions happen to be around the same as those of the hedge funds themselves).

Here’s a quick analogy we find useful:  Flip a coin 100 times, and when you’re done, have a look at the distribution. Normal with a mean of 50, right? Now imagine flipping another coin at the same time. Both distributions should be roughly the same. Both will have a mean of around 50 and be normally distributed. So you’d be indifferent between the two coins. But the coins still won’t produce the same results in lock-step with each other. In fact, they will produce different results around half the time. That’s the thinking behind Harry Kat’s hedge fund replication methodology. He doesn’t aim to literally replicate the monthly returns (i.e. in their exact same order). Instead he aims to replicate the return characteristics of hedge funds (their means, standard deviations, skewedness, kurtosis and even their near-zero correlations to various securities).

Factor models aren’t replication, they’re a faint resemblance

Kat cites research from various big names that shows factors can only explain about 20% of the volatility of individual hedge funds and around 50% of the volatility of hedge fund indexes.

But Kat says his methodology explains (or more accurately “replicates”) nearly 90% of the volatility of hedge funds by trading only 5 basic futures contracts in a highly complex option-like manner.  His software tool, Fund Creator constructs an exotic option by dynamically trading these futures contracts in a manner that yields the desired distribution characteristics.

He saves his best barbs for hedge fund indexes which, he says, simply compound the problems with high hedge fund fees. He replicates the HFR and EDHEC hedge fund indexes and finds that, in several cases, Fundcreator actually produced a higher return. When asked about why his replicated means so closely approximate the actual means of his target distributions, he responds that the hedge fund managers generate returns that are simply commensurate with the risks they take.  In other words, most hedge funds don’t produce alpha according to Kat.  So beating them isn’t that hard.

The ensuing panel discussion revealed some disagreement with the audience of hedge fund managers and with fellow panelists who immediately commenced a game of gotcha.  Kat wasn’t phased though and deflected most shots without missing a beat.

An academic whose first career in the investment banking business made him independently wealthy, Kat is obviously not in this for the money. And that’s what makes him so dangerous to his competitors (hedge funds and investment banks). He seems to be motivated primarily by a desire to challenge the status quo.  In a sense, he is a “non-economic player” in the asset management industry itself.

With evangelical zeal and his trademark bluster, Kat concluded his session by saying: Twenty percent of hedge fund managers can produce alpha after fees. But you can’t tell which 20% it is. They all look the samethe same Armani suits, the same Rolexes and the same Bentleys.

The Armani-clad, Rolex-wearing, Bentley-driving attendees in the audience weren’t sure whether Kat was playing a huge joke on them, or if this was the beginning of the end of the hedge fund industry as we know it.

And that was rather unsettling for all.

– Alpha Male

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One Comment

  1. Carvalhor1
    February 14, 2007 at 4:33 am

    The fact that Kat’s strategy does not replicate the short-term returns of hedge funds, just mimics the distribution of returns, means that it should likely exhibit low-correlation with most hedge fund strategies. That could make the case for Kat’s strategies as extra source of diversification but not necessarily a replacement of hedge funds. The second question is liquidity. What is the capacity of a fund implementing Kat’s algorithms? Since it uses futures it is likely to be large but nevertheless limited. I would be rather surprised it can cope with the USD 2 trillion currently chasing alpha in the hedge fund world.

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