Most investors who buy traditional assets –stocks, bonds, commodities – have a series of misconceptions about the risks associated with hedge fund investments. Much of the press coverage of the hedge fund industry focuses on high-profile hedge fund problems. In fact, the overriding majority of hedge funds are highly risk averse, seeking to generate modest positive returns in all types of underlying market environments. Risk control and capital preservation are two of the areas where the best hedge funds consistently excel.
Investors who have exclusively used traditional fund management practices over the past 10 years or so, are now confronted with a new set of market problems. Firstly, traditional fixed income investors are faced with low absolute rates in many markets, and the continuing fear of rises in official interest rates, and the spectre of inflation looming in many economies, due to rising commodity prices and higher wage pressures. Secondly, traditional equity investors are faced with extreme market volatility and sudden sector rotations. Traditional equity indices are steadily becoming dominated by a relatively small number of companies - increasingly those with a technology focus.
Many institutional investors are turning to alternative investments as a way of maintaining acceptable levels of return, while dampening portfolio volatility. Increased attention is being paid to risk-adjusted returns, particularly in the measurement of downside deviation – the variance of returns below a specific threshold, such as T-Bills. When selecting hedge funds, our approach seeks to identify skill-based processes which lead to consistently low downside deviation statistics:
Equity long/short (also referred to as market hedged)
This is by far the largest category of hedge funds in terms of numbers of managers pursuing the strategy. The primary source of return for the vast majority of these managers is based on stock selection rather than market timing.
Market neutral or ‘relative value strategies’
Market neutral or ‘relative value managers’ attempt to isolate alpha and target a beta of zero to all markets. They seek to do this by identifying and exploiting pricing inefficiencies between related instruments, or combinations of instruments.
Tactical trading strategies
Trading managers speculate on the direction of market prices of currencies, commodities, equities and bonds in the futures and cash markets. Typical investment horizons vary considerably, but the key is that they can quickly reverse their market view as they see a situation unfold.
Event-driven strategies
These are strategies where the key deciding factor is some kind of capital markets transaction. Managers must assess the expected value of the securities they invest in upon completion of the transaction, the time likely to be involved before completion, and the possibility that the transaction will not be completed at all. Thus the profitability of investments depends upon the successful conclusion of an event within the anticipated time frame.
What are the risks?
The main risks of hedge fund investment are divided into two parts: ‘manager-specific risks’ and ‘portfolio-specific risks’. The key manager risks are (inter alia):
o Style drift (deviation from stated rules, disciplines and processes)
o Excessive leverage, reducing efficient market access
o Poor risk management disciplines, particularly in volatile markets
o Managers distracted from day-to-day running of trading activity
o Uncontrolled asset growth
o Breakdown in back-office functions
o Main strategy becomes less viable (competition, more efficient markets)
o Decreased transparency of processes
The key portfolio-specific risks are:
o Insufficient diversification
o Poor sector allocation
o Hidden macro biases
The only way to minimise these risks is to perform extremely thorough due-diligence so that the managers’ processes are clearly understood, followed by regular, intensive monitoring to ensure adherence to these processes. Portfolios of hedge funds need to be constructed by experts who have a clear understanding of the macro biases inherent in many hedge fund strategy sectors, and can operate a sector allocation process which can minimise the risk of loss in a wide variety of underlying market situations. The reward for investors who buy well-constructed portfolios of carefully selected hedge funds should be steady, positive returns in all market conditions.
Due diligence check list
The list below is designed to be a non-exhaustive list of areas for hedge fund manager assessment. It is important that the due-diligence is performed by individuals with a thorough practical and intellectual understanding of hedge fund investment techniques.
o Personnel: experience, competence, track record, references, are the key principals committed both intellectually and with their own capital?
o Organisation: back office independence, office administration, secure relationships with prime brokers, administrators and other service providers, contingencies, are the key investors too highly concentrated/not fully committed?
o Investment approach: strategy well defined and viable, strategy consistently well implemented, are risk and return expectations consistent with investment style and objectives, does investment approach offer sustainable edge over competitors?
o Risk management: transparent description of risk management disciplines and processes, position limits, sector concentrations, which types of securities are traded, frequency and transparency of portfolio reporting, will the processes described stand up to extreme market conditions?
o Performance evaluation: Audit process – are returns consistent with processes described and the manager’s peer group, is the manager demonstrating consistent use of skill-based techniques, or have returns been based on favourable market environments or luck?
John Capaldi is with Financial Risk Management in London