Hedge funds are sometimes marketed as high-return, low-correlation investments that may present diversification advantages to conventional portfolios. Traders should look past the advertising pitch, nevertheless, to totally perceive the dangers concerned. Leverage, brief 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 submit is the second in a three-part sequence analyzing 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 submit, 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, brief promoting, and by-product 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 likely to ship modest common earnings — 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 principal lender ceases to offer financing, requiring the fund to seek out one other lender or liquidate belongings to repay its debt. Traders ought to pay shut consideration to financing danger. Financing danger is important, as Barth et al. (2023) report that just about half of hedge fund belongings are financed with debt.
Additionally vital 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. Below a excessive redemption state of affairs, the fund could need to promote its most liquid, highest-quality belongings first, leaving the remaining traders with a much less beneficial portfolio, resulting in extra redemptions.
Below one other state of affairs, 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’ skill to get rid of their funding at will, Aiken et al. (2020) recommend hedge funds with a lock-up are likely to outperform because of their larger publicity to equity-mispricing anomalies.
Diversification Properties
Analysis usually 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 categorised 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 larger 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 opponents. In different phrases, low-correlation hedge funds are likely to ship larger risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a distinct 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 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 official diversifiers, however investing in this kind of 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 stage 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. Nevertheless, traders shouldn’t oversimplify the difficulty. First, conventional danger measures like normal deviation and correlation are incomplete. Skewness and kurtosis have to be measured or estimated indirectly. Merchandise with low historic normal deviation could disguise the potential of occasional excessive losses or a unfavorable anticipated return. Traders should totally perceive the fund’s funding technique and the way it could behave underneath adversarial situations. Traders should additionally mirror 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 official 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 at all times seize the total image — skewness, kurtosis, and tail-risk publicity are essential issues.
My last submit on this sequence will clarify why I don’t suggest hedge funds.
