NY Metro Hedgefund Law & News

On to Kurtosis

Kurtosis describes the shape of a random variable’s probability density function. Consider the three curves shown in the chart below (click the chart to expand it into a pop up).

The chart illustrates the notion of kurtosis. The red curve has the highest kurtosis. It is the most peaked at the center and has wider tails. The blue curve is in the middle. The green curve has the least kurtosis. It is flatter at the center and has the narrowest tails.

Incidentally, one can’t tell from looking at the chart which curve has the highest or lowest standard deviation*. The red line is more peaked at the center, which might lead one to believe that it has a lower standard deviation. It has fatter tails, which might lead one to believe that it has a higher standard deviation. If the effect of the peakedness exactly offsets that of the fat tails (or vice versa in the case of the green line), each curve will have the same standard deviation.

A normal random variable (the blue curve) has a kurtosis of 3 irrespective of its mean or standard deviation. If a random variable’s kurtosis is greater than 3 (the red curve), it is said to be leptokurtic. If its kurtosis is less than 3 (the green curve), it is said to be platykurtic. Leptokurtosis is associated with densities that are simultaneously “peaked” and have “fat tails.” Platykurtosis is associated with densities that are simultaneously less peaked and have thinner tails.

What does this mean to a hedge fund investor? Well it means that a fund with high kurtosis (i.e. 3+ and therefore, leptokutic) has exhibited more frequent behavior at the extremes (the "tails") than a fund with a lower kurtosis.

If you want to see a relatively accessible discussion of kurtosis and (from my prior blog entry) skew I suggest you look at this working paper by Harry M Katt entitled "Integrating Hedge Funds into the Traditional Portfolio".

*"Standard deviation" is a very traditional portfolio risk measure which will be discussed in a future blog.

Hedge Fund Risk - Part I Skew

An investor in a hedge fund normally wants to look at its risk.

Typical risk measures don't always work well with hedge funds which may exhibit behaviors more statistically extreme than other types of investment. Extreme behavior is often called behavior at the "tails". (This will be explained in more detail below and in later blogs).

One item that is examined to measure hedge fund risk at the tails (or extremes) is "skew".

A distribution is skewed if one of its tails is longer than the other. If you click on the chart below it should pop up for you.

The green distribution shown has a positive skew. This means that it has a long tail in the positive direction. The red distribution has a negative skew since it has a long tail in the negative direction. Finally, the blue distribution is symmetric and has no skew. Distributions with positive skew are sometimes called "skewed to the right" whereas distributions with negative skew are called "skewed to the left."

So, as a "tool" only,  it would be a positive indicator if a fund behaved with returns showing a positive skew, neutral if a fund behaved with a neutral skew, and a negative if a fund behaved with a negative skew.

Of course, a fund does not always behave going forward in the same manner as the past - so that is certainly a caveat. Also I must put in my usual disclaimer that I am not an investment adviser.

Coming soon in this blog:  "kurtosis".

New Minimum Net Worth Standard for Hedge Funds?

The U.S. Securities and Exchange Commission said on Tuesday it is moving to increase the minimum net worth required for an investor to be eligible to invest in hedge funds to $2.5 million from $1 million.

The five-member SEC is expected to vote on the proposal at an open meeting on Wednesday.

SEC Chairman Christopher Cox told reporters at a briefing he expects approval to put the proposal out for public comment. Final action by the investor protection agency would come later.

"We are going to be lifting the accredited investor standard from where it has been since 1982 at $1 million of net worth to $2.5 million," Cox said.

The increase is approximately equal to an inflation adjustment from 1982 and also reflects "our sense of what matters and what is meaningful," Cox said.

Free-wheeling and loosely policed, hedge funds have become a powerful market force. Their assets under management have doubled to more than $1.3 trillion over the past five years.

As they have grown -- there are nearly 9,000 now -- hedge funds have expanded from their original client base of rich people and institutional investors to also take in money from the less well-to-do, raising government concerns about risk and suitability.

The SEC's proposed rule, if adopted, would shut the door on a lot of the just-barely wealthy who have been piling into hedge funds lately, although one market analyst said it would likely not affect larger funds with big clients.

"The impact is going to be on the smaller hedge funds," said Adam Sussman, senior analyst at TABB Group, which tracks the hedge fund industry. "People starting a hedge fund are going to have a harder time raising capital."

The kinds of assets an investor could count toward meeting the $2.5 million cut-off would include securities in public companies and certain private companies, the SEC said.

Real estate held for investment, as well as commodity interests, physical commodities and financial contracts held for investments could be counted. So could cash and cash equivalents, but not an investor's personal residence or place of business, the SEC said.

The new proposed minimum net worth -- known as the accredited investor standard -- would be higher than the present standard, which varies depending on the investor.

The base minimum is $1 million or $200,000 in net income for two consecutive years. The effective minimum net worth is already $1.5 million for hedge funds that charge performance fees, as most do.

At the upcoming meeting, the SEC will also consider tightening up its anti-fraud rules as applied to hedge funds.

"We're putting in place a sturdy anti-fraud rule that is tailor-made for hedge funds," Cox said.

A Glimpse of the Future - Hedge Fund Study Bill Received in Senate

Congress is looking at a Hedge Fund Study Act. Currently the bill (HR 6079) has been passed by the House and received by the Senate. To become law it would have to be passed by the Republican Senate during the current post-election congressional session.

Given the need for Republican support passage does not seem assured. However, the bill was introduced by Rep. Barney Franks who is expected to become Chairman of the House Financial Services Committee in the 110^th Congress so it is in all likelihood at least a glimpse of things to come.

The areas which would be studied are:

(1) the changing nature of hedge funds and what characteristics define a hedge fund;

(2) the growth of hedge funds within financial markets;

(3) the growth of pension funds investing in hedge funds;

(4) whether hedge fund investors are able to protect themselves adequately from the risk associated with their investments;

(5) whether hedge fund leverage is effectively constrained;

(6) the potential risks hedge fund pose to financial markets or to investors;

(7) various international approaches to the regulation of hedge funds; and

(8) the benefits of the hedge fund industry to the economy and the markets.

A report would be issued not later than 180 days after enactment as to:

(1) any proposed legislation relating to appropriate disclosure requirements for hedge funds;

(2) the type of information hedge funds should disclose to regulators and to the public;

(3) any efforts the hedge fund industry or regulators of financial institutions should undertake to improve practices or provide examples of successful industry initiatives; and

(4) any oversight responsibilities that members of the President's Working Group should have over the hedge fund industry, and the degree and scope of such oversight.