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, nonetheless, to completely perceive the dangers concerned. Leverage, brief promoting, and derivatives can introduce hidden vulnerabilities, whereas charge buildings might encourage methods that generate regular positive aspects however expose traders to occasional deep losses.
This put up is the second in a three-part collection inspecting 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 put up, 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 industrial databases.
Hedge Fund Dangers
Because of the permitted use of leverage, brief promoting, and spinoff product methods, some hedge funds are extremely unstable. Their uneven charge buildings 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 — probably 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 fundamental lender ceases to offer financing, requiring the fund to seek out one other lender or liquidate property 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 property are financed with debt.
Additionally vital is liquidity danger, which materializes when too many traders redeem their shares concurrently. This danger is especially critical for hedge funds holding comparatively illiquid property. Underneath a excessive redemption situation, the fund might should promote its most liquid, highest-quality property first, leaving the remaining traders with a much less helpful portfolio, resulting in extra redemptions.
Underneath one other situation, the supervisor might 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 eliminate their funding at will, Aiken et al. (2020) counsel hedge funds with a lock-up are inclined to outperform because of their increased 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 labeled 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 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 increased Sharpe Ratios, info ratios, and alphas than their opponents. In different phrases, low-correlation hedge funds are inclined to ship increased risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a special conclusion. He constructed giant 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 might characteristic substantial systematic danger. The writer additionally finds that the low R-squared property will increase the chance of fund failure.
Brown (2016) claims that hedge funds are reputable 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 vital and constant diversification advantages to traders, no matter their degree of danger aversion.” 4 methods provide 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 traders because of their dependable diversification advantages.
Past Conventional Threat Measures
Analysis reveals that hedge funds may also help diversify portfolios. Nonetheless, traders mustn’t oversimplify the difficulty. First, conventional danger measures like normal deviation and correlation are incomplete. Skewness and kurtosis should be measured or estimated ultimately. Merchandise with low historic normal deviation might conceal the potential of occasional excessive losses or a destructive anticipated return. Buyers should totally perceive the fund’s funding technique and the way it might behave underneath hostile situations. Buyers should additionally replicate on what danger means underneath 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 reputable 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 fastidiously. Conventional danger measures like normal deviation and correlation don’t all the time seize the total image — skewness, kurtosis, and tail-risk publicity are crucial issues.
My remaining put up on this collection will clarify why I don’t suggest hedge funds.
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, nonetheless, to completely perceive the dangers concerned. Leverage, brief promoting, and derivatives can introduce hidden vulnerabilities, whereas charge buildings might encourage methods that generate regular positive aspects however expose traders to occasional deep losses.
This put up is the second in a three-part collection inspecting 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 put up, 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 industrial databases.
Hedge Fund Dangers
Because of the permitted use of leverage, brief promoting, and spinoff product methods, some hedge funds are extremely unstable. Their uneven charge buildings 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 — probably 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 fundamental lender ceases to offer financing, requiring the fund to seek out one other lender or liquidate property 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 property are financed with debt.
Additionally vital is liquidity danger, which materializes when too many traders redeem their shares concurrently. This danger is especially critical for hedge funds holding comparatively illiquid property. Underneath a excessive redemption situation, the fund might should promote its most liquid, highest-quality property first, leaving the remaining traders with a much less helpful portfolio, resulting in extra redemptions.
Underneath one other situation, the supervisor might 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 eliminate their funding at will, Aiken et al. (2020) counsel hedge funds with a lock-up are inclined to outperform because of their increased 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 labeled 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 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 increased Sharpe Ratios, info ratios, and alphas than their opponents. In different phrases, low-correlation hedge funds are inclined to ship increased risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a special conclusion. He constructed giant 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 might characteristic substantial systematic danger. The writer additionally finds that the low R-squared property will increase the chance of fund failure.
Brown (2016) claims that hedge funds are reputable 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 vital and constant diversification advantages to traders, no matter their degree of danger aversion.” 4 methods provide 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 traders because of their dependable diversification advantages.
Past Conventional Threat Measures
Analysis reveals that hedge funds may also help diversify portfolios. Nonetheless, traders mustn’t oversimplify the difficulty. First, conventional danger measures like normal deviation and correlation are incomplete. Skewness and kurtosis should be measured or estimated ultimately. Merchandise with low historic normal deviation might conceal the potential of occasional excessive losses or a destructive anticipated return. Buyers should totally perceive the fund’s funding technique and the way it might behave underneath hostile situations. Buyers should additionally replicate on what danger means underneath 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 reputable 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 fastidiously. Conventional danger measures like normal deviation and correlation don’t all the time seize the total image — skewness, kurtosis, and tail-risk publicity are crucial issues.
My remaining put up on this collection will clarify why I don’t suggest hedge funds.
