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 and marketing pitch, nevertheless, to completely perceive the dangers concerned. Leverage, quick promoting, and derivatives can introduce hidden vulnerabilities, whereas price constructions could encourage methods that generate regular positive aspects however expose traders to occasional deep losses.
This publish 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 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 industrial databases.
Hedge Fund Dangers
Because of the permitted use of leverage, quick promoting, and spinoff product methods, some hedge funds are extremely unstable. Their uneven price 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 income — 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 important lender ceases to offer financing, requiring the fund to seek out one other lender or liquidate belongings to repay its debt. Buyers ought to pay shut consideration to financing danger. Financing danger is important, as Barth et al. (2023) report that nearly half of hedge fund belongings are financed with debt.
Additionally necessary 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 situation, the fund could need to promote its most liquid, highest-quality belongings first, leaving the remaining traders with a much less worthwhile portfolio, resulting in extra redemptions.
Beneath one other situation, the supervisor could freeze redemptions to stop 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) recommend hedge funds with a lock-up are inclined to outperform resulting from their larger 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 combined 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 unique 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 creator additionally finds that the low R-squared property will increase the likelihood of fund failure.
Brown (2016) claims that hedge funds are reputable diversifiers, however investing in any such 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 supply 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 resulting from their dependable diversification advantages.
Past Conventional Threat Measures
Analysis reveals that hedge funds can assist diversify portfolios. Nevertheless, traders mustn’t oversimplify the problem. 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 opportunity of occasional excessive losses or a adverse anticipated return. Buyers should completely perceive the fund’s funding technique and the way it could behave beneath adversarial circumstances. Buyers should additionally mirror on what danger means beneath their particular circumstances. Sacrificing an excessive amount of anticipated return for diversification may 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 rigorously. Conventional danger measures like commonplace deviation and correlation don’t at all times seize the total image — skewness, kurtosis, and tail-risk publicity are essential concerns.
My last publish on this collection will clarify why I don’t advocate hedge funds.
