GLOBAL - The Bank of New York Mellon (BNY Mellon) has suggested hedge funds should be differentiated by 'cluster analysis', instead of categorising them by investment style.

In a joint study with research firm Oxford Metrica of around 3,000 hedge funds, half were identified as providing stable return when grouped in several clusters according to the observed behaviour in their returns.

Almost a further 900 were labelled "outliers" which fared much better or much worse than the other funds, while the rest were defined as "drifters" which, for various reasons, switch from cluster to cluster.

Funds in the stable clusters "perform better" and some are less volatile than equity indices, David Aldrich, managing director at BNY Mellon, pointed out, arguing "volatility is not a good label to apply to hedge funds".

He explained "outliers" are funds with managers who were considered "either geniuses or off the rails" so it was for the portfolio managers to decide whether or not to include them. But according to Aldrich, all strong performing hedge fund of funds have some "outliers" mixed into the portfolio.

Rory Knight, principal of Oxford Metrica, confirmed Amaranth would have fallen into the "outliers" category of his company's research.

"Drifters are lack-lustre. Funds that drift from one cluster to another tend to underperform," said Aldrich.

Knight suggests categorisation of hedge funds should be made available to investors at least every six months, but perhaps even quarterly as he thinks this would make it easier for managers to construct their own hedge fund of funds portfolios.

Hedge funds, on the other hand, could use this categorisation to distance themselves from Amaranth and label themselves either 'unique' if they fall into the "outliers" category or 'stable' if in a cluster, Knight confirmed.

If funds then fall under the 'drifters' label, they will have to explain whether their drifting is intentional or by chance, he added.

"The need for this research comes from the inherent opaqueness of hedge fund managers," Knight noted. His research therefore uses the observable behaviour showing in the fund's returns.

BNY Mellon said this research was aimed at aiding the adoption of best practice in the hedge fund industry.

"So far, hedge fund managers did not need to be very transparent publicly because they were dealing with a small group of knowlegeable investors. But now that pension funds and insurers are investing more in this asset class, there is a great deal more interest in transparency and best practice," Aldrich explained.

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