Hedge funds are sometimes marketed as high-return, low-correlation investments that may present diversification advantages to conventional portfolios. Buyers should look past the advertising pitch, nevertheless, to totally perceive the dangers concerned. Leverage, brief promoting, and derivatives can introduce hidden vulnerabilities, whereas payment constructions could encourage methods that generate regular good points however expose traders 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 spinoff 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 offer financing, requiring the fund to search out one other lender or liquidate belongings to repay its debt. Buyers ought to pay shut consideration to financing danger. Financing danger is critical, as Barth et al. (2023) report that just about half of hedge fund belongings are financed with debt.
Additionally essential is liquidity danger, which materializes when too many traders redeem their shares concurrently. This danger is especially severe for hedge funds holding comparatively illiquid belongings. Beneath a excessive redemption state of affairs, the fund could should promote its most liquid, highest-quality belongings first, leaving the remaining traders with a much less helpful portfolio, resulting in extra redemptions.
Beneath one other state of affairs, the supervisor could freeze redemptions to forestall a liquidation spiral. Hedge funds typically cut back liquidity danger by imposing an preliminary lock-up interval. Whereas such restrictions hamper traders’ capacity to get rid of their funding at will, Aiken et al. (2020) counsel hedge funds with a lock-up are inclined to outperform attributable to 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 categorised as inefficient on a stand-alone foundation can produce an environment friendly payoff profile when blended with the S&P 500 Index. Kang et al. (2010) discovered that the longer the funding horizon, the better 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 inclined to ship larger risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a special 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 writer 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 this kind 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 important and constant diversification advantages to traders, no matter their degree of danger aversion.” 4 methods provide extra average advantages, and just one technique doesn’t enhance portfolio diversification. Apparently, 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 traders attributable to their dependable diversification advantages.
Past Conventional Danger Measures
Analysis exhibits that hedge funds can assist diversify portfolios. Nonetheless, traders mustn’t oversimplify the difficulty. First, conventional danger measures like commonplace deviation and correlation are incomplete. Skewness and kurtosis have to be measured or estimated ultimately. Merchandise with low historic commonplace deviation could conceal the potential for occasional excessive losses or a detrimental anticipated return. Buyers should completely perceive the fund’s funding technique and the way it could behave below hostile circumstances. Buyers should additionally replicate on what danger means below their particular circumstances. Sacrificing an excessive amount of anticipated return for diversification might 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 traders should consider rigorously. Conventional danger measures like commonplace deviation and correlation don’t all the time seize the total image — skewness, kurtosis, and tail-risk publicity are essential issues.
My remaining publish on this sequence will clarify why I don’t advocate hedge funds.
