Professor Harry Kat

Independent thinking

Simon Kerr
Originally published in the February 2005 issue

There are a couple of definitions of the word critic given in the Oxford English Dictionary. One definition is "one given to harsh or captious judgement ". To some it would seem an apt word to categorise Harry Kat, Professor of Risk Management and Director Alternative Investment Research Centre at Cass Business School, City of London, in regard to hedge funds.

Over the last couple of years he has given presentations titled "Do Funds of Hedge Funds Add Value", "Do Funds of Hedge Funds Work?", and "The Problems with Hedge Funds". As a set of titles they suggest an author with a sceptical bent, and indeed that is a label Kat has applied to himself. Not that hedge funds have been his sole interest in the four to five years since he returned to full-time academic work. Professor Kat has applied his knowledge of derivative structuring gained in his time at Bank of America and First Chicago to the problems of pension fund funding/deficits. For example he has proposed investment strategies using options to narrow the gap between pension fund liabilities and current asset size invested.

In the hedge fund area Professor Kat's work has answered a series of questions driven off the returns of hedge funds: what have been the underlying historic returns of hedge funds, given the shortcomings of data; what are the statistical properties of hedge funds' returns; and, given the characteristics of hedge fund returns, how should investors build portfolios of hedge funds and use such funds of funds in combination with traditional asset classes? Each of these areas of work will be looked at before hearing from Kat in his own words.

Kat examined hedge fund attrition and survivorship bias in a paper (2003) co-authored by Gaurav Amin of University of Reading ISMA Centre. The paper, headed somewhat melodramatically "Welcome to the Dark Side", looked at data over the period 1994-2001. In it hedge funds were shown to exhibit a high rate of attrition that has increased substantially over time. At a recent conference Professor Kat gave the current attrition amongst hedge funds as 15%. Kat and Amin in their paper showed that lack of size, lack of performance and an increasingly aggressive attitude of old and new fund managers alike were the main factors behind increasing attrition. Although attrition was high, survivorship bias in hedge fund data was quite modest, which reflected the relatively small difference in performance between surviving and defunct funds. Concentrating on survivors only will over-estimate the average hedge fund return by around 2% per annum they found. For small, young, and leveraged funds, however, the bias can be as high as 4-6%. This finding should be borne in mind when looking at fund vehicles dedicated to new funds. The two authors also found significant survivorship bias in estimates of the standard deviation, skewness and kurtosis of individual hedge fund returns. When not corrected for, this will lead investors to seriously overestimate the benefits of hedge funds.

The most widely read paper of Harry Kat's has been "Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?" (2001, also co-authored with Amin). In this paper they investigated the claim that hedge funds offer investors a superior risk-return trade-off. The evaluation model, which did not require any assumptions with regard to the return distribution of the funds in question, was applied to the monthly returns of 77 hedge funds and 13 hedge fund indices over the period May 1990-April 2000. The results showed that as a stand-alone investment hedge funds do not offer a superior risk-return profile. They found 12 indices and 72 individual funds to be inefficient, with the average efficiency loss amounting to 2.76% per annum for indices and 6.42% for individual funds. Part of the inefficiency cost of individual funds could be diversified away. When Kat and Amin looked at hedge funds in a portfolio context it resulted in a marked improvement in the evaluation outcomes: seven of the 12 hedge fund indices and 58 of the 72 individual funds classified as inefficient on a stand-alone basis were capable of producing an efficient pay-off profile when mixed with the S&P 500.

Building on his work with Amin, Professor Kat has worked with Sa Lu of the University of Reading to go beyond the simplistic risk-return framework to look at the higher moments in hedge fund returns. Work in this area enables informed investors in hedge funds to take the drug of hedge fund investment strategies whilst having full knowledge of the side effects (kurtosis, skewness, autocorrelation) on the body of the patient (asset mix). Their 2002 paper "An Excursion into the Statistical Properties of Hedge Fund Returns" provides an overview of the most important statistical properties of individual hedge fund returns. They found that the net-of-fees monthly returns of the average individual hedge fund exhibit significant degrees of negative skewness, excess kurtosis, as well as positive first-order serial correlation. The correlations between hedge funds in the same strategy group were of the same order of magnitude as the correlations between funds in different strategy groups, and relatively low. This gives some credence to those who emphasis the bottom-up element of portfolio construction. The paper found that compared to individual funds, portfolios of hedge funds tended to exhibit lower skewness, higher serial correlation and higher correlation with stocks and bonds. Finally, an equallyweighted portfolio of all funds in their sample offered a 2.76% higher mean return than the average fund of funds. This strongly suggested to Kat and Lu that the timing and fund picking activities of the average fund of funds was not rewarded by a higher return. To put it in a commercial context, the commercial funds of funds have the onus on them to prove from where their added-value arises.

Some of Harry Kat's work with Sa Lu and Ryan Davies of Babson College last year also looked at funds of hedge funds. This concentration seems very appropriate at the moment as so much of hedge fund industry flows are coming through funds of funds. Further, institutional investors in hedge funds are driving how funds of funds companies build their portfolios and organise their businesses, so the statistical properties of funds of funds both independently and in the context of rich asset mixes is the risk management hot-spot of the whole industry at the moment.

The Davies/Kat/Lu paper "Single Strategy Funds of Hedge Funds" gave a simple method to predict how the (higher order) return properties of a single strategy fund of hedge funds will vary as one or more funds are added to, or removed from, the portfolio. The approach taken was model-free, but consequently data manipulation intensive, and used average co-moments obtained from the universe of available funds to develop a functional relationship between portfolio return distributions and the number of funds in the portfolio. The authors showed that some single strategy funds of hedge funds may be under-diversified and that co-variance, co-skewness, and co-kurtosis, rather than variance, skewness and kurtosis, matter most in portfolio diversification. This work reflects another stage of maturity of the industry generally as funds of hedge funds are being constructed from narrow ranges of strategies (specialist vehicles) as broader more diversified products (funds of funds) are readily available, even at the retail level.

Another paper produced by the same authors last year, "Fund of Hedge Funds Portfolio Selection: A Multiple-Objective Approach", reflected different signs of industry maturity. In its naivety the hedge fund industry used to use two-dimensional frames of reference (the Sharpe-ratio) and assume normality in return distributions for convenience so that widely available tools like mean-variance-based optimisers could be co-opted (or mis-applied, depending on perspective). This paper incorporated investor preferences for return distributions and higher moments into a Polynomial Goal Programming (PGP) optimisation model. In a reflection of how hedge funds should be used in an institutional context, this allowed the trio of authors to solve for multiple competing hedge fund allocation objectives within a mean-variance-skewness-kurtosis framework. Interestingly, irrespective of investor preferences, the PGP optimal portfolios contain hardly any allocation to long/short equity, distressed securities, and emerging markets funds. Equity market neutral and global macro funds on the other hand tend to receive very high allocations, primarily due to their low co-variance, high co-skewness and low co-kurtosis properties. More specifically, equity market neutral funds act as volatility and kurtosis reducers, while global macro funds act as portfolio skewness enhancers (see Q&A below). Bringing in the whole fund asset mix gave equivalent results: in PGP optimal portfolios of stocks, bonds, and hedge funds, where equity exposure tends to be traded-off for hedge fund exposure, they observed a similar preference for equity market neutral and global macro funds.

The alternative Oxford English Dictionary definition of critic is perhaps better suited to Harry Kat than the first. "A critic is one who expresses a reasoned opinion on any matter especially involving a judgement of its value, truth, righteousness, beauty, or technique." Professor Kat offers reasoned opinion not unfounded assertion, and his more recent work should help those whose job it is to provide portfolios of hedge funds to construct those products with full knowledge provided to the end-investor of some of the give-to-get that hedge fund investing entails. Whilst this may not require "righteousness" or "beauty", providing hedge fund portfolios to institutional investors absolutely requires techniques Professor Harry Kat takes to public platforms on a frequent basis to facilitate the end-investors as well as their intermediaries to invest knowledgeably in hedge funds. So if the function of a critic is to inform his audience, it is one the Professor gladly and ably fulfils.

Q & A with Harry Kat

Here are Kat's thoughts on some of the issues concerning hedge fund investing today.

Institutional investors seem to accept that hedge fund returns will be lower in future than they have been historically. What is your view?

I see returns coming in at a little over the interest rate on a savings account. Returns have been coming down over the years, and they will continue to come down further. The performance of hedge funds will not be anywhere near that seen historically.

Do investors in hedge funds need position-level data?

Such data is only useful if the investor is on it every day. You have to be in the flow of it and really use the data to draw conclusions about the risk management of the hedge fund that is being observed and whose data is being analysed. It is the risk control processes that an external assessor should be getting to grips with: trying to get an understanding of what you expect is going to be done with the positions and exposures as they are, given market changes and how you know the manager operates. To some extent you are trying to get into the manager's head. For example, given the set up and style of the fund, what would you expect the manager to sell first (in a liquidity crunch)?

Has there been a key influential academic paper on the topic, in a way that, say, Harry Markowitz's 1952 paper was the foundation of MPT?

No, there has been no single paper on hedge funds that has set the direction of research in the same way.

In what direction do you see academic work on hedge funds going?

There's not too much left really, partly through the lack of data. That is not to deny that there is a boom in academic papers going on. If you look at the SSRN (Social Science Research Network) you will see plenty of papers have been written [Search Results for "hedge funds" on the SSRN Abstract Database gives 301 results, and "fund of hedge funds" gives 253 references in the database]. The rest (what is to come) will be applications of tools to data-sets, and the conclusions will necessarily be biased given the well-recorded shortcomings of hedge fund data.

Who are the most influential academics looking at hedge funds?

There are only really four groups of academics looking at hedge funds. There is Narayan Naik [Associate Professor ofFinance; Director, Centre for Hedge Fund Research and Education at London Business School] and Bill Fung at London Business School [Fung often works with David Hsieh of Duke University], Thomas Schneeweis [Director of Center for International Securities and Derivatives Markets and Professor of Finance at U. Mass], the guys at EDHEC [led by Lionel Martellini, Professor of Finance at EDHEC Business School and the Scientific Director of the EDHEC Risk and Asset Management Research Centre] and CASS Business School. Sure many other academics have looked at hedge funds for one paper, but they move on. So there are only four that look at the topic seriously.

What was it that brought you to look at hedge funds in the first place?

During my time at D.E. Shaw (a unit of Bank of America) I had written a book 'Structured Equity Derivatives' [July 2001, John Wiley & Sons] and a head-hunter had heard of the book, and maybe even read it, who knows? Anyway, he called and talked to me about a position as head of research at a large fund of hedge funds group. That got me having a look at hedge funds, and soon I was thinking "how can hedge funds charge these fees – 2 and 20, and 1 and 10 (for funds of funds)?" Then (around 2000) there was this claim of superior returns of hedge funds. They could "produce higher returns for the same risk, or produce equivalent returns with lower volatility". I thought those claims merited serious attention [see Kat H, Menexe, F. (2003) Persistence in Hedge Fund Performance: The True Value of a Track Record, Journal of Alternative Investments, and An Excursion into the Statistical Properties of Hedge Fund Returns (2002 Working Paper)].

Does having a practical background in derivatives help in looking at hedge funds?

It means I'm looking at hedge fund strategies from an academic and a practical point of view. It means I know what to look for, the right questions to ask of a strategy or manager. I think having had real markets experience makes me more cautious and sceptical than a typical investor. When it comes to a strategy that is like someone making money by betting that they can consistently jump across a railway track. I know that I will see it for what it is. On the other side I believe I can bring a better intuition than many academics to the work. Hedge fund analysis means working with a short history of data, and poor quality data at that. Whilst some academics seem to operate by stuffing that data, whatever its characteristics, into a PC, I will never simply do that. I will always look beyond the data.

Do you have any consulting arrangements with practitioners in the hedge fund business?

No, I do this because I enjoy it. I don't need to do it, and so it is by choice that I have no consultancy arrangements here. This stance allows one to be objective. I have been asked to engage in one-off projects for people and organisations that have known me for a while, but they do not implement hedge fund strategies in markets themselves. So I have that objectivity. For similar reasons the Alternative Investment Research Centre at Cass is not sponsored. In our way of operating we have little overhead; our only requirement is data. So if we do get money for research it goes on buying data. In fact there is only data in our Centre. (Monetarily) we can last for ever operating this way. Others (ie academic researchers in hedge funds) have three year deals for tens of thousands of pounds a year, but to me that just raises expectations. The sponsoring organisations will review these arrangements after a few years. If there is any disappointment the sponsors can pull out leaving the researchers rather exposed. Plus, there can be a need for those receiving sponsorship to justify themselves: you know, feeling they have to produce a newsletter, so putting a rope around their own necks. We just do research – no conferences, no bullshit, just research.

The average tenure of a hedge fund manager has decreased significantly. Does the change have any impact on the academic treatment of the subject, and should it affect the behaviour of those that invest in hedge funds?

This is an area of investing where it is harder to keep data clean. The track records are short and getting shorter, so one is able to take less of a view of what is going on. That means that returns cannot be taken at face value, you have to understand what the investment strategy involves. For example, I know of a manager that has been using a strategy of selling puts since 2002, and he is up 500% since then, and with no losing months. The great track record does not mean there is no risk just because it has not shown up yet. For any good performance there has to be some form of risk-taking going on. If the record is too good to be true (for the given strategy) it probably isn't a true record or there is more to the strategy than has been disclosed.

If you were running the Kat Family Office now would you include hedge funds in your own asset mix?

Yeah, I would include global macro funds and equity market-neutral strategies – these strategies are definitely interesting – and I would get some commodity exposures too. In terms of the newer alternative strategies, like weather-related trading and insurance plays, I am not as interested. I ask myself, is there a weather risk-premium, is there somebody in the underlying markets for these strategies willing and able to pay me for taking on the risk involved?

Is there anything else you want to add?

What do you call a hedge fund that's closed? Open. What do you call a hedge fund that is open for investment now? Down.


Biography Harry Kat, Ph.D.

Harry M. Kat is Professor of Risk Management at the Sir John Cass School of Business at City University in London and Director of the Alternative Investments Research Centre at City University. Before returning to academia, Harry was Head of Equity Derivatives Europe at Bank of America in London, Head of Derivatives Structuring and Marketing at First Chicago in Tokyo and Head of Derivatives Research at MeesPierson in Amsterdam. He holds MBA and Ph.D. degrees in economics and econometrics from the Tinbergen Graduate School of Business at the University of Amsterdam and is a member of the editorial board of The Journal of Derivatives and The Journal of Alternative Investments.

Current Research Grant (with Joelle Miffre): Skewness, Kurtosis and the Conditional Performance of Hedge Funds sponsored by Inquire UK.

Selected Publications:
Kat H, T. Kocken, and H. Capelleveen (2004) How Derivatives Can Help Solve the Pension Fund Crisis Journal of Portfolio Management

Kat H, (2004) Managed Futures and Hedge Funds: A Marriage Made in Heaven Journal of Investment Management

Kat H, (2004) The Dangers of Mechanical Investment Decision-Making Journal of Investment Management

Kat H, Amin, G. (2003) Hedge Fund Performance 1990 – 2000: Do the Money Machines Really Add Value?, Journal of Financial and Quantitative Analysis

Kat H, Amin, G. (2003) Stocks, Bonds and Hedge Funds: Not a Free Lunch! Journal of Portfolio Management

Kat H, (2002) Structured Equity Derivatives John Wiley & Sons