It all comes back to risk
Hedge funds differ from traditional pension fund investments in three main ways: leverage, shorting and the use of exotic – and possibly illiquid – instruments, all of which have an impact on risk. Leverage is unidirectional; increasing leverage necessarily increases risk, and a low risk strategy can be transformed into a high risk one simply by the addition of leverage. Being unregulated, each individual fund will operate its own internal restrictions. Knowing the leverage policy of the fund is critical to being able to predict whether individual strategy risks will be crystallised through liquidations at the worst possible prices to fund margin payments. Accounting-based measures of leverage are of limited use in assessing risk1, and experts recommend methods that relate the riskiness of the portfolio (including market risk, counterparty credit risk and liquidity risk) to the fund’s ability to absorb losses.
The underlying instruments used is not the key driver to risk, rather it is how they are used in strategy deployment (see table). In general, unidirectional strategies are the riskiest, as market risk is clearly unhedged. Trading strategies using uncorrelated assets add diversification, but are still reliant on correctly anticipating market moves. Long and short exposures in the same asset class remove some element of market risk, but are dependent on manager skill in identifying relative value. Arbitrage strategies, which take advantage of historically tested incidences of mean reversion offer greater certainty of return, but suffer in market dislocations when these relationships break down.
Instrument liquidity has a number of knock-on effects, from ease of trading at close to valuation prices, through to the capacity of the fund administrator to verify market prices. Although valuable arbitrage opportunities can often be found in illiquid instruments, infrequency of trading means that one cannot rely on extracting that value, and the tendency of the price to gap breaks a fundamental tenet of risk models. Even for funds investing primarily in liquid instruments, increasing fund size erodes performance at the margin, and in extreme market conditions creates the possibility of NAV losses if fund positions exceed market volumes.
Some strategies have a longer time horizon than others. For instance, the typical statistical arbitrage play lasts a matter of days, whereas buying distressed securities in anticipation of corporate restructuring could mean a holding period of many months. Here, risk can accumulate. For example, a strategy that relies on holding illiquid securities until a change in the pricing basis will be more vulnerable to investor withdrawals. Similarly, global macro, which involves taking a few large leveraged fundamental bets, albeit on liquid instruments like government bonds and currencies, can also involve long holding periods, and intermediate losses.
The standard deviation of returns can be a useful measure for assessing risk, with the caveat that reducing liquidity means that the manager may be able to influence the fund’s NAV. Many arbitrage strategies can maintain consistent positive returns for long periods, but are at risk to ‘tail events’ which have a small probability of occurring but a large cost. Fixed income arbitrage, which exploits small price discrepancies between similar bond market instruments, has been likened to the sale of disaster insurance2, which generates reliable inflows of premiums for a long period before suffering a large payout. Because of the very fine terms on which this strategy operates, it needs to be leveraged many times to achieve meaningful absolute returns. Here potential investors should look at the extent of drawdowns, where these have occurred, as an indicator of potential losses.
For more volatile strategies the ratio of winning months to losing months and the maximum single loss can be a good guide to the typical pattern of returns. But past performance will not be a good predictor of future performance, particularly if the style of the fund has subtly shifted in the interim.
All hedge fund strategies rely on market volatility to create trading opportunities, and strategies that exploit pricing anomalies on derivative instruments, such as convertible bonds (CBs) and longer-dated options and warrants, rely on continuing volatility for profitable hedging and to mitigate other risk factors. As Alex Ribaroff, founder of Concordia Capital, remarks on CB arbitrage, “a relatively orderly widening of credit spreads is not a problem if it is matched by an increase in stock volatility”.
However, almost all strategies break down in extreme market volatility, often through an accumulation of risks such as dislocation in historic price relationships, difficulty in borrowing stock, lack of liquidity, and a worsening credit scenario, both in terms of the hedge fund’s ability to obtain financing and the pricing of corporate bond holdings. The equity market neutral strategy, normally at the lower end of the risk spectrum, will suffer particularly during any period of turmoil, but bounces back smartly when normal market conditions return.
Measuring risk can be difficult, because strategies exploit market inefficiencies or structural change, whereas risk models will typically assume a normal distribution of returns and the persistence of historic correlations. A good example is merger arbitrage, where opposing positions in acquiror and acquiree are taken according to the likelihood of a deal going through. Stock correlations before the deal was announced are now immaterial.
When so much of the risk is at the individual share level, and linked to a corporate or legal event, the only alleviation is through diversification, although in a market downturn a number of deals could simultaneously disintegrate, causing short-term losses and an ongoing lack of corporate activity that will dampen future returns. It is the business of the merger arbitrageur to be aware of and profit from corporate events; statistical arbitrage players will more likely be caught out by takeover activity, because the relative pricing of the two stocks will suddenly change to a different basis.
Certain strategies contain risks that cannot be easily or cheaply hedged. Gottex, a fund of fund adviser, looks for an awareness of these risks and a proper assessment of the cost and viability of hedging. For example, within the subset of convertible bond arbitrage known as Reg D, where low credit quality companies privately place convertibles on premium terms, the poor credit and lack of liquidity may be unhedgeable, but the manager should be able to demonstrate that the undervaluation of the security is sufficient reward for the increased risk.
Peter Bennett, chief investment officer at Gottex, is scathing in his assessment of systematic trading strategies that aim to generate returns by making numerous bets on many different markets on the basis of market momentum or chart patterns. Bennett prefers to invest in arbitrage strategies where the returns are calculable, on the basis of mean reversion or the correction of a price anomaly, and where the risks can be readily identified and accounted for. Within CB arbitrage, Bennett looks to ensure that the fund can deal with the rare situation where suddenly worsening credit causes the bond floor to decline precipitously. As this will generally correlate with a falling equity price, a stock put could be bought, or a credit swap used.
An investor in equity market neutral funds should diversify across different managers in this segment to mitigate the risk of a breakdown in the assumptions on which any one model is based. Funds should have complementary orientations, to diversify residual market and economic factors like growth, value, or a small cap or sector bias.
Although equity long/short is an undeniably popular strategy, accounting now for almost 50% of the hedge fund market (see pie chart), it relies to a great extent on manager skill, both for individual stock selection and determining net market exposure. According to Jan Willem Baan, director of investments at TPG KPN Pensioen in the Netherlands, which has invested in two US equity long/short hedge funds, the managers’ risk control is as important as their ability to generate alpha, and investors should only invest if they understand fully the risks and how they can be controlled. However, the risk of this strategy is generally significantly lower than the standard long-only equity strategy, where an inability to go into cash or go short and the existence of tracking error targets limit the manager’s ability to deal with market downside and specific sector volatility.
Any strategy involving a large number of positions in different instruments will suffer from operational risk and this is aggravated by having many counterparties.
Institutional investors are increasingly looking for a second opinion on the risk profile of funds in which they are invested. GlobeOp Financial Services can access the position reports of hedge funds to provide analysis on concentration, limit monitoring, compliance and value-at-risk, using its own proprietary adjustments to market standard models. Performance attribution reports identify clearly from what aspect of the strategy a fund is achieving returns, and expose any latent unhedged risk.
Claire Smith is a freelance journalist specialising in hedge funds