Pinpointing the causes of risk
‘No, we don’t [currently invest in hedge_funds]! It is completely obvious that hedge funds don’t work. We are not a casino.”
This is a statement from an investor quoted in the Ludgate hedge fund survey from March 2000. Note that the survey was conducted at chief investment officer level. We find it interesting that there are many investors willing and legally permitted to invest in a business model attempting to corner the global market for dog food via the internet but are unwilling or restricted from investing with some of the most talented people in the financial industry. In this article we want to highlight some aspects of investing in hedge funds with respect to risk to the investor. In a nutshell we believe there are three main attributes to investing in hedge funds: high absolute, positive risk-adjusted returns, preservation of principal (risk management) and aligning interests of investor and manager.
One of the most used measures of risk-adjusted returns of funds is the Sharpe ratio. This is defined as the total (normally annual) return minus the risk-free rate over the volatility (annualised standard deviation) of the fund. This approach implies that volatility is a synonym for risk – one of the standard (and anachronistic) assumptions of modern portfolio theory.
If risk was measured by the variance of returns (of which the square root is the standard deviation) then most investors should be invested 100% in hedge funds. The historical ‘risk-adjusted’ returns (as measured by the Sharpe ratio) are superior to any other asset class, even when the poor quality of the available data (survivorship bias) is taken into account. This – interestingly – was suggested by an author in the winter 1999 edition of The Journal of Investing1.
Although we advocate allocations to hedge funds as appropriate for most long-term investors, a 100% allocation seems inappropriate. The reason is that many of the risk factors to hedge fund investors are not measured by variance of returns. Any portfolio construction tool (for example, mean-variance optimisation) that equates risk with variance of returns is therefore incomplete. We believe a large proportion of the investor universe (institutional as well as private) puts a big questionmark behind the notion that volatility of returns is equal to risk. The three main reasons for volatility of returns not being an appropriate measure for risk are non-normal return distributions, liquidity risk and systemic risk.
Hedge fund returns are not normally distributed around the mean expected return. The concept of variance – and therefore Sharpe ratios – is based on the assumption that returns are normally distributed. The recent history of equity markets suggests that this assumption is a rather extreme departure from reality. More importantly, returns from hedge fund portfolios are not normally distributed. The return distributions of some of the hedge fund strategies that employ leverage are negatively skewed (to the left, with a long tail to the left) and leptokurtic (narrow distribution with outliers). The presence of statistical outliers or ‘fat tails’ is of particular interest in terms of assessing risk. If returns are not normally distributed, Sharpe ratios do not work for measuring risk-adjusted returns and mean-variance optimisations are inappropriate for portfolio construction purposes.
The return distribution of some relative-value strategies resembles the cashflow distribution of an insurance company selling disaster insurance. The insurance company’s cashflow distribution is also negatively skewed and leptokurtic. It will generate a positive (insurance) premium in most market conditions (small cash inflows) and experience a large cash outflow in exceptional market conditions (in a disaster scenario). This cash flow distribution does not imply that selling insurance premium is a bad business to be involved in. The key is to determine whether the many small cash inflows will exceed the few large outflows in the long term.
The figure compares the frequency distribution of monthly returns in fixed income arbitrage – traditionally the hedge fund strategy that uses the highest degree of leverage – with the normal distribution of fixed income arbitrage and the JPM Global Bonds Index. It highlights the deviation of the historic return distribution from normality.
Hedge funds, like private equity, are alternative investment strategies. This means these investments are normally private placements, ie, are not marketable securities. Risk measures that might work for marketable securities are not necessarily applicable to investments that are not marketable. Non-marketability or reduced liquidity is a risk to the investor. The investor cannot exit the investment as easily as a portfolio of UK large caps. The investor expects to get paid for that type of risk and will want to pick up a liquidity premium. Again, this type of risk is not measured by the variance of returns.
Some investors might find comfort in the fact that most hedge fund managers have a large portion of their net wealth tied to the fund, ie, the same high redemption periods as the investor. A more pragmatic argument for low liquidity is the fact that hedge funds exploit inefficiencies and therefore are by definition in markets that are less liquid than the bluest of blue chips. In other words, exploiting inefficiencies by its nature involves some degree of illiquidity.
Most hedge funds are less transparent than their long-only peer group. We believe that the lack of transparency is a similar risk factor to the lack of liquidity. An investor should expect to be compensated for both risk factors, ie, pick up a premium for the lack of liquidity as well as transparency. Full transparency of current positions is commercially unwise. This is true for hedge funds and proprietary trading desks as well as other money managers of large size. The reason why it is more important for hedge funds is because they involve short positions much more frequently than traditional funds. In many regions, traditional money managers are restricted from selling short. Short positions require more sensitive treatment than long positions. Many equity hedge funds are involved in illiquid markets, as the inefficiencies are higher than in liquid markets. The results of being squeezed out of a short position in an illiquid market can be disastrous to overall portfolio performance. One way of controlling this risk is by not unveiling one’s positions to the market.
We believe there is also a systemic risk factor to the asset class. However, numerous academic research studies have shown that hedge funds were not the cause of the Asian crisis or other major world economic collapses. We believe it is true that in today’s financial markets, capital reacts quickly to information.
As a result, when countries or firms fail to live up to their promises – over-build, over-buy, over-monetise – funds flee and the market reacts quickly. While such capital flight may have its own associated problems, the alternative to free flows is almost always worse. If investors are afraid of an inability to retrieve capital, it simply will not go there in the first place.
The hedge fund industry is in a much earlier stage in its industry life cycle. In addition, hedge funds are often domiciled offshore and unregulated. The investor investing in hedge funds should be aware of the fact that the legal investor protection can be of a different nature than with traditional long-only funds. Any investor investing in hedge funds should be aware of this type of risk and should expect to get compensated for carrying the risk. The point again is that regulatory risk is not measured by the volatility of returns.
The near collapse of Long-Term Credit Management is often referred to as example of systemic risk. Many hedge funds failed before LTCM, and many could fail in the future. Some failed quietly, returning some investor capital after liquidating positions. Others, like LTCM, failed in a more spectacular fashion. The failure of a single firm or investment product is always of concern to the investors as well as those who invest in similar ventures. However, modern investment theory points out that no person or institution should have a sizeable portion of their wealth invested in any one product.
In short, unless one has a perfect forecast of the future, diversification is laudable concept with dealing with uncertainty. The stock market has survived the bankruptcy of many companies. This does not mean that stocks are bad investments. It does not even mean that the investors in a company that loses money ex post initially made the wrong choice. The most notable aspect of LTCM is not in its near collapse, but the fact that many highly sophisticated investors held a large portion of their wealth in the single fund, which is completely contrary to modern investment principles.
We believe that diversified hedge fund investors have been compensated for the various forms of risks in the past. We are equally convinced today that investors who have the ability and capacity to identify and invest with the most talented hedge fund managers are able to increase the efficiency of their portfolios – traditionally biased to equities and/or bonds.
Alexander Ineichen is head of equity derivatives research at UBS Warburg in London
1 McFall Lamm, R, 1999, “Portfolios of alternative assets: why not 100% hedge funds?” Journal of Investing, Vol 8, No 4, Winter, pp 87–97