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 completely perceive the dangers concerned. Leverage, quick promoting, and derivatives can introduce hidden vulnerabilities, whereas payment constructions could encourage methods that generate regular positive aspects however expose buyers to occasional deep losses.
This publish is the second in a three-part sequence inspecting hedge fund literature to evaluate their dangers and their diversification potential and providing insights on when and the way they may match into an funding technique. In my first publish, I present that the analysis suggests ability and alpha are scarce and troublesome to acquire within the hedge fund market, particularly amongst these listed in business databases.
Hedge Fund Dangers
As a result of permitted use of leverage, quick promoting, and by-product product methods, some hedge funds are extremely risky. Their uneven payment constructions additionally incentivize the adoption of funding methods with negatively skewed outcomes and excessive kurtosis. In different phrases, many hedge funds are inclined to ship modest common earnings — presumably to generate efficiency charges — at the price of occasional deep losses.
Hedge funds utilizing leverage additionally bear financing danger, which materializes when the fund’s foremost lender ceases to supply financing, requiring the fund to search out one other lender or liquidate belongings to repay its debt. Traders ought to pay shut consideration to financing danger. Financing danger is important, as Barth et al. (2023) report that just about half of hedge fund belongings are financed with debt.
Additionally vital is liquidity danger, which materializes when too many buyers redeem their shares concurrently. This danger is especially critical for hedge funds holding comparatively illiquid belongings. Below a excessive redemption situation, the fund could should promote its most liquid, highest-quality belongings first, leaving the remaining buyers with a much less priceless portfolio, resulting in extra redemptions.
Below one other situation, the supervisor could freeze redemptions to stop a liquidation spiral. Hedge funds typically scale back liquidity danger by imposing an preliminary lock-up interval. Whereas such restrictions hamper buyers’ capability to get rid of their funding at will, Aiken et al. (2020) recommend hedge funds with a lock-up are inclined to outperform attributable to their greater publicity to equity-mispricing anomalies.
Diversification Properties
Analysis typically 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 higher 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 greater Sharpe Ratios, info ratios, and alphas than their opponents. In different phrases, low-correlation hedge funds are inclined to ship greater risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a unique 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 danger. The creator additionally finds that the low R-squared property will increase the likelihood of fund failure.
Brown (2016) claims that hedge funds are respectable diversifiers, however investing in the sort of 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 vital and constant diversification advantages to buyers, no matter their degree of danger aversion.” 4 methods supply extra reasonable 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 attributable to their dependable diversification advantages.
Past Conventional Threat Measures
Analysis exhibits that hedge funds can assist diversify portfolios. Nevertheless, buyers shouldn’t oversimplify the difficulty. First, conventional danger measures like normal deviation and correlation are incomplete. Skewness and kurtosis should be measured or estimated not directly. Merchandise with low historic normal deviation could conceal the opportunity of occasional excessive losses or a damaging anticipated return. Traders should totally perceive the fund’s funding technique and the way it could behave underneath hostile situations. Traders should additionally mirror on what danger means underneath their particular circumstances. Sacrificing an excessive amount of anticipated return for diversification may hurt monetary well being in the long term.
Key Takeaways
Hedge funds can function respectable diversifiers, however blind allocation is dangerous. Whereas sure methods have proven constant diversification advantages, others introduce financing, liquidity and excessive loss dangers that buyers should consider rigorously. Conventional danger measures like normal deviation and correlation don’t at all times seize the total image — skewness, kurtosis, and tail-risk publicity are vital issues.
My closing publish on this sequence will clarify why I don’t suggest hedge funds.
