Inconsistencies in hedge fund classification are causing widespread confusion and are preventing investors from truly diversifying their portfolios, according to a recent study.
The report by United States-based Bank of New York Mellon recommended hedge funds be classified using cluster analysis rather than by strategy.
Cluster analysis would group the funds, not by management style, but by observed behaviour.
"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 maximise alpha," the report said.
"The resulting style drift is the cause of much difficulty in benchmarking and investor understanding."
Bank of New York Mellon managing director David Aldrich said recent volatility in equity markets was a real stress test for the hedge fund industry.
"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," Aldrich said.
The study, which was conducted in conjunction with research firm Oxford Metrica, looked at a universe of 5282 hedge funds.
It found there were three common myths that surround hedge funds.
It said the common perception that hedge funds were volatile was false.
"The analysis reported shows that most categories of style and strategy, on average, are less volatile than the equity markets," the report said.
The second myth was that all hedge funds generate pure alpha.
The study concluded, however, that despite the ubiquity of the absolute return epithet in the industry, hedge fund returns were increasingly beta driven.
The final myth challenged was that all hedge funds contribute little marginal risk to a core equity portfolio.
The report said, however, that because hedge fund returns converged with equity returns, investors were not getting true diversification.
"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 principal of the report's co-sponsor Oxford Metrica Rory Knight said.
