Beyond the Marketing Pitch: Understanding Hedge Fund Risks and Returns

Hedge funds are sometimes marketed as high-return, low-correlation investments that may present diversification advantages to conventional portfolios. Traders should look past the advertising pitch, nonetheless, to totally perceive the dangers concerned. Leverage, brief promoting, and derivatives can introduce hidden vulnerabilities, whereas payment buildings could encourage methods that generate regular positive factors however expose buyers to occasional deep losses.

This publish is the second in a three-part sequence analyzing hedge fund literature to evaluate their dangers and their diversification potential and providing insights on when and the way they could match into an funding technique. In my first publish, I present that the analysis suggests talent and alpha are scarce and troublesome to acquire within the hedge fund market, particularly amongst these listed in business databases.

Hedge Fund Dangers

Because of the permitted use of leverage, brief promoting, and by-product product methods, some hedge funds are extremely unstable. Their uneven payment buildings additionally incentivize the adoption of funding methods with negatively skewed outcomes and excessive kurtosis. In different phrases, many hedge funds are likely to ship modest common earnings — probably to generate efficiency charges — at the price of occasional deep losses.

Hedge funds utilizing leverage additionally bear financing threat, which materializes when the fund’s foremost lender ceases to offer financing, requiring the fund to search out one other lender or liquidate property to repay its debt. Traders ought to pay shut consideration to financing threat. Financing threat is important, as Barth et al. (2023) report that just about half of hedge fund property are financed with debt.

Additionally necessary is liquidity threat, which materializes when too many buyers redeem their shares concurrently. This threat is especially severe for hedge funds holding comparatively illiquid property. Below a excessive redemption situation, the fund could must promote its most liquid, highest-quality property first, leaving the remaining buyers with a much less precious portfolio, resulting in extra redemptions.

Below one other situation, the supervisor could freeze redemptions to forestall a liquidation spiral. Hedge funds usually cut back liquidity threat by imposing an preliminary lock-up interval. Whereas such restrictions hamper buyers’ skill to get rid of their funding at will, Aiken et al. (2020) recommend hedge funds with a lock-up are likely to outperform resulting from their larger publicity to equity-mispricing anomalies.

Diversification Properties

Analysis usually acknowledges modest diversification advantages with hedge funds. Amin and Kat (2009) discovered that seven of the 12 hedge fund indices reviewed and 58 of the 72 particular person funds categorized as inefficient on a stand-alone foundation can produce an environment friendly payoff profile when combined with the S&P 500 Index. Kang et al. (2010) discovered that the longer the funding horizon, the larger the diversification advantages of hedge funds.

Titman and Tiu (2011) studied a complete pattern of hedge funds from six databases and concluded that low R-squared funds exhibit larger Sharpe Ratios, data ratios, and alphas than their rivals. In different phrases, low-correlation hedge funds are likely to ship larger risk-adjusted returns.

Bollen (2013) additionally checked out low R-squared hedge funds and got here to a distinct conclusion. He constructed massive portfolios of a number of zero R-squared hedge funds. He discovered that these portfolios have as much as half the volatility of different hedge funds, suggesting that, regardless of appearances, zero R-squared hedge funds could function substantial systematic threat. The writer additionally finds that the low R-squared property will increase the likelihood of fund failure.

Brown (2016) claims that hedge funds are legit diversifiers, however investing in such a product with out deep operational due diligence is outright harmful. Newton et al. (2019) reviewed 5,500 North American hedge funds that adopted 11 distinct methods from 1995 to 2014. They report that six methods “present important and constant diversification advantages to buyers, no matter their stage of threat aversion.” 4 methods provide extra average advantages, and just one technique doesn’t enhance portfolio diversification. Curiously, their measure of diversification advantages accounts for skewness and kurtosis.

Lastly, Bollen et al. (2021) discovered that regardless of a extreme decline of their efficiency since 2008, a 20% allocation to hedge funds nonetheless reduces portfolio volatility however fails to enhance Sharpe Ratios. They conclude {that a} modest allocation to hedge funds could also be justified for risk-averse buyers resulting from their dependable diversification advantages.