Bill Fung, PhD (London), PhD (Manchester), is Visiting Research Professor of Finance, London Business School; Chairman of the Board of Directors, Maple Financial Group; and Vice-Chairman of the Research Foundation of CFA Institute.

We had the opportunity recently to interview Bill Fung, Visiting Professor of Finance of London University and Vice-chair of the Research Foundation of CFA Institute, on the foundation’s work, which includes 16 monographs in just the past four years, covering timely topics as diverse as the global financial crisis, risk management, Islamic finance, behavioural finance, guidance for investment trustees, and most recently, the role of emotions in investment decision-making. Professor Fung’s comments reflected his extensive background in both the financial industry and the academic world, touching on topics such as the status of quantitative research post-2008, the evolution of behavioural finance, and the performance of hedge funds over the last decade. Extracts from our interview are presented below.

Has the status of quantitative research been reduced as a result of the financial crisis?

Effective risk management cannot be practised without quantitative tools. Detailed evidence of successful applications of quantitative investment strategies are rarely, if ever, available publicly. Quantitative strategies tend to be rule-based and replicable, so successful managers are reluctant to reveal their successful investment rules for others to copy. Successful applications of quantitative tools tend to be like unsung heroes—seldom heard about. But I should say that despite its contributions toward developing quantitative tools, the research Foundation is not focused primarily on quantitative research. We are keenly aware of the behavioural and institutional aspects of managers and investors. As part of our product portfolio, we have published research into many of the behavioural aspects of investing, including our latest monograph on the subject of emotional finance. In fact, one of our most popular monographs is the recently published guide for investment trustees, which tackles the fiduciary aspect of managing assets. These publications should be viewed in a portfolio context in order to appreciate the balance between the different kinds of research and topics we are trying to achieve over a production cycle of three to five years.

The Research Foundation welcomes suggestions for future research topics from local societies.

Is the foundation amenable to suggestions about topics for funding research?

Yes, we are trying to be more proactive in reaching out to the CFA membership to better communicate our mission and to solicit their ideas. We now have a full-time executive director, Bud Haslett, who, together with the support of trustees in our marketing and planning committee, has been working diligently to promote awareness of Research Foundation activities and to present our output in the appropriate context to the membership worldwide. For instance, Bud has artfully leveraged our access to distinguished monograph authors to initiate an “authors circle” from which Research Foundation authors (and its trustees) can be drawn to participate in local society events on topics relating to recent and planned research publications. I have just done several such events in Asia (China, Vietnam, South Korea, Hong Kong, and in Japan last year). The process has started in which we are now receiving suggestions for future research topics from local society leaders. We are in the process of translating some monographs into other languages in cooperation with local society leaders and have plans to expand this in the future.

As a specialist in hedge funds, how do you see the hedge fund industry evolving over the next several years in the wake of the severe and lingering global financial crisis, which some would argue hedge funds had a role in exacerbating?

The events of 2008 remind us of the importance of managing funding risk, which calls for skillful management of margins and collaterals. Hedge fund research encompasses many exciting and challenging features. For instance, it reminds us that the theory of portfolio diversification works, but it has to be applied to both sides of the balance sheet—assets as well as liabilities.

As leveraged, active participants to global markets, it is not surprising that hedge funds were in most cases unwitting participants in the 2008 financial crisis. However, I have not come across convincing, systematic empirical evidence that hedge funds exacerbated the crisis. The Rand Corporation has just released a report, Hedge Funds and Systemic Risk, in which it concluded that hedge funds can contribute to systemic risk, but they were not the primary cause of the 2008 financial crisis. Professor David Hsieh and I published a paper on the role of hedge funds in the 1997 Asian currency crisis that documented empirical evidence leading to not dissimilar conclusions.

It is not surprising that the secretive nature of hedge funds often makes them the natural choice as culprits whenever there are adverse market events that are otherwise hard to explain. However, documenting supporting empirical evidence calls for collecting hard-to-observe data on hedge fund activities and serious research efforts to analyze them. It is easy to speculate and lay the blame at the doorstep of opaque speculators, but proving it is a different matter.

How would you assess the performance of hedge funds generally over the last turbulent decade?

To put the question in perspective, in a recent research paper, my co-authors and I showed that at the end of the first decade in this millennium, over 90% of assets invested in the hedge fund industry are managed by less than 15% of the total number of hedge fund management companies—a trend that appears to be continuing. A large proportion of the top hedge fund management companies do not disclose their data to the general public. We spent a great deal of time collecting performance data from various sources on those hard-to-observe large hedge fund firms. Out of the top 100 hedge fund firms we have gathered data on over 95% of them— data that spans the past decade. We created firm-wide performance statistics on the funds these mega hedge fund firms manage.

Eliminating the usual measurement biases, a dollar invested in the top 50 firms returned 93.65% over the 2002 to 2010 period, net of all fees and expenses. By way of comparison, the Dow Jones Credit Suisse Broad Index of hedge funds returned 91.51% versus the S&P 500 index, which returned (inclusive of dividends) 30.59%. Certainly a substantial amount of this excess performance over the S&P 500 index came from losing less money in 2008, but capital preservation by these mega hedge fund firms is not the whole story. It is also true that 2011 was a disappointing year for hedge funds. But then, if you invest with the big funds, the redemption process is often in excess of six months. Therefore, I very much doubt that year-to-year performance is the decisive input to investors in the hedge fund industry, which since the turn of the century has been mostly dominated by institutional investors.

Over the past decade, there has been an increasing concentration of leverageable risk capital into a small number of players.

In the future, when we look back on today’s global financial industry, what do you believe will be seen as the most important changes?

I don’t think we have enough time to discuss all of Dodd-Frank, so let me limit my remarks to the regulations affecting practitioners of active leveraged investment strategies. Ten years from now, I think most people will agree that regulations have failed to recognize the unprecedented credit expansion that was fuelled in large part by assuming certain types of collateral to be “safe as houses,” when in fact they were far from being as safe as we thought. Current regulations have gone a long way towards improving transparency and have erected speed bumps to slow the movement of collateral (limiting the use of re-hypothecation and naked short sales). We have also gone a long way towards addressing the imbalance between rewarding agents for taking risks that paid off and the lack of recourse when bets go awry. I think we still have a way to go in our search for the optimal principal–agent contract for our industry. But perhaps no such legal contract can survive the challenge of talented arbitrageurs. Talent can be both an asset and a liability.

Going forward, ethics have to be a key component of our professional training, and the investment industry has made great strides in this direction. Regulators should take this industry development into account in setting future regulations.

Are there any risks in today’s financial system that keep you awake at night?

There is still an aspect of liquidity risk that concerns me. I still remember that in 1993, if one had polled market participants on the “best” trade in the market, most would have responded “the convergence trade in European bonds.” That strategy went well until Greenspan’s unexpected rate hikes in 1994. There are of course other instances of convergence of opinion that led to dramatic reductions in market liquidity. Post 2008, we learned that convergence risk can also occur on the funding side of the balance sheet. The events of August 2007 remind us that a collateral squeeze can quickly spill over to the asset side, creating a fire sale of risky assets.

Over the past decade, there has been an increasing concentration of leverageable risk capital into a small number of players. Now, smart hedge fund managers are a diverse lot and generally don’t like crowded trades. Nonetheless, the risk exists that they may independently arrive at the same “great idea.” Monitoring such convergence risk on both the asset and liability side of dynamic opaque fund managers remains a challenging task. In a 24-hour global marketplace, this is a problem that can surface any time.

How has the field of investment research changed in the last decade? Are investors looking for different things or for different outcomes from the investment research they are reading?

Yes, in one word—technology. When investment ideas can be delivered and executed on a cell phone, you know that things have changed! Not only does content matter, the delivery mechanism and speed also matter. Like trading strategies, investment research has become more polarized into high-frequency ideas with very short shelf life (and getting shorter) and strategic research, which, ironically, is taking longer to produce as issues become more complex. But you can’t expect to produce a quality product overnight! Quality takes time, and time is a luxury in this business. We are fortunate at the research Foundation to be able to afford the luxury of tackling the strategic end of the investment research market.

And we are fortunate to have such a productive research Foundation working on our behalf.

The Research Foundation of CFA Institute can be found online at www.cfainstitute.org and provides access to over 100 monographs as well as numerous partnered publications, occasional papers, and literature reviews.