Rethinking performance in the hedge fund industry, recommends that hedge funds be classified using cluster analysis instead of the traditional classification by strategy. Cluster analysis groups funds according to the observed behavior in their returns, as opposed to management styles.
Traditional hedge fund indices are challenged by increasing demands to demonstrate transparency of the underlying funds and many hedge funds may change their strategy to maximize alpha. The resulting style drift is the cause of much difficulty in benchmarking and investor understanding.
In classifying 5,282 hedge funds, the study found that: -- Stable clusters perform better - some investors may wish to invest only in funds whose performance does not fluctuate greatly, or that represent a larger class of funds -- Outliers are loners that can do well or very poorly - some investors will be happy to take the risk of a unique fund but Amaranth is an example of one which went wrong -- Drifters are lack-luster - funds that drift from one cluster to another tend to under perform
David Aldrich, managing director, The Bank of New York Mellon, said: "The recent volatility in the equity markets was a real stress test for the hedge fund industry and should be seen as a springboard for new industry efforts to increase overall investor confidence and to manage return expectations. Increased transparency of the underlying funds, and the use of cluster analysis for fund classification, will help identify a fund's true investment strategy and highlight any style drift, which collectively will improve investor confidence."
Dr. Rory Knight, principal of Oxford Metrica, said: "Cluster analysis adds a time dimension to the classification of hedge funds and thereby allows a robust means of evaluating any drift in style over time. A major issue for the industry as a whole is to manage risk, return and correlation - alpha will need to be proven to justify the fee structure."
The study removes three common myths surrounding hedge funds: -- Hedge Fund Myth #1: All hedge fund returns exhibit high volatility. The analysis reported shows that most categories of style and strategy, on average, are less volatile than the equity markets. -- Hedge Fund Myth #2: All hedge funds generate pure Alpha. Despite the ubiquity of the "absolute return" epithet in the industry, hedge fund returns are increasingly systematic or beta driven. -- Hedge Fund Myth #3: All hedge funds contribute little marginal risk to a core equity portfolio. As hedge fund and equity returns converge these vehicles are less effective diversification media.
This paper is the fourth is a series of thought leadership papers published by The Bank of New York Mellon addressing key issues facing the alternative investment management industry, including "Institutional Demand for Hedge Funds" and "Hedge Fund Operational Risk: meeting the demand for higher transparency and best practice".

The Bank of New York Mellon
The Bank of New York Mellon Corporation is a global financial services company focused on helping clients manage and service their financial assets, operating in 37 countries and serving more than 100 markets. The company is a leading provider of financial services for institutions, corporations and high-net-worth individuals, providing superior asset management and wealth management, asset servicing, issuer services, clearing services and treasury services through a worldwide client-focused team. It has more than $20 trillion in assets under custody and administration, more than $1.1 trillion in assets under management and services $11 trillion in outstanding debt. Additional information is available at bnymellon.com.

Oxford Metrica
Oxford Metrica is an independent research and analytics firm in international investments. The firm focuses on risk, value, reputation and governance - the strategic aspects of financial performance. Oxford Metrica aims to provide evidence-based support for key management decisions. Oxford Metrica also provides research and analytics to several hedge fund managers particularly those involving emerging markets and multi-manager strategies.
Hedge funds are big “consumers” of credit. To pacify their lenders, the funds had to sell some assets at lower prices. There are many kinds of hedge funds and some were more susceptible to the credit crunch than others.

Hedge funds fall into two main groups: single-strategy funds and multistrategy funds. Single-manager, single-strategy funds are the least diversified  while multi manager, multistrategy funds are the most diversified.
Is it wise to invest in hedge funds? Those who invest in multiple hedge funds for the long term will find some positive elements in the August occurrences: charlatans have gone, the statistical models will be re-examined and new knowledge will accumulate among the organizations that can afford to do research.
Hedge funds are primarily a private pool of money, or rather private funds managed by professionals. Broadly, they can be viewed as a mutual fund of a select few high-net worth and high-risk investors.

Hedge versus Mutual funds
Hedge Funds Mutual Funds
These involve a group of private investors, and minimal regulations. These involve public money, and are highly regulated.
A limited number of investors. A higher number of investors.
High minimum investment. Low minimum investment.
Can be highly leveraged. Can’t be leveraged.
Highly flexible with their investment pattern. Follow strict investment guidelines, hence are rigid.
High fees. Low fees, usually fixed by the regulators.
Open only through private placement, usually offered to well-informed, high risk-appetite investors. Open to the public.
Disclosure requirements are minimal. Disclosure requirements are high.