What is “complexity” and is it really to blame?
Feb 24th, 2008 | Filed under: Hedge Fund Industry TrendsNorth Americans woke up Saturday morning to two major newspaper stories that blame recent financial upheaval on the sheer complexity of hedge fund strategies. The Wall Street Journal proclaimed that “Hedge Funds Feel New Heat” and Canada’s Globe and Mail announced that “Statistical geniuses of finance at the banks and hedge funds got it wrong.” Both articles rely heavily on anecdotal evidence. But unlike the mutual fund industry, the hedge fund industry does not lend itself to such extrapolation. This is because manager dispersion within each hedge fund category is relatively large. As a result, such anecdotes – the bread and butter for mainstream hedge fund coverage - are a poor indicator at best and misleading at worst.
For example, the Journal article argued that,
“The past decade has been the era of the hedge fund, as investors snapped them up for their track record of beating the market with often highly complex trades. But now, as the credit crunch upends financial markets, that very complexity is coming back to bite some of them.”
This is a fair hypothesis (and one that we have also made in the past). But the anecdotal examples held up as proof would likely be branded as “curve-fitting” by statisticians. One hedge fund cited in the article faced problems with its real estate holdings, one had “improper accounting”, and one “got burned dabbling in debt”. None of these drawdowns were blamed explicitly on excessive complexity. In fact, the only drawdown explicitly blamed on excessive complexity was actually run by a bank.
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[...] “Complexity exists all around us in many well-managed forms. Blaming hedge fund drawdowns on complexity is like blaming the complexity of your laptop when it crashes.” (All About Alpha) [...]