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 and marketing pitch, nonetheless, to totally perceive the dangers concerned. Leverage, quick promoting, and derivatives can introduce hidden vulnerabilities, whereas charge constructions could encourage methods that generate regular features however expose traders to occasional deep losses.
This put up is the second in a three-part collection 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 put up, I present that the analysis suggests ability and alpha are scarce and tough to acquire within the hedge fund market, particularly amongst these listed in industrial databases.
Hedge Fund Dangers
As a result of permitted use of leverage, quick promoting, and spinoff product methods, some hedge funds are extremely unstable. Their uneven charge 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 — probably 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 primary lender ceases to offer financing, requiring the fund to seek out one other lender or liquidate property to repay its debt. Traders ought to pay shut consideration to financing danger. Financing danger is important, as Barth et al. (2023) report that nearly half of hedge fund property are financed with debt.
Additionally necessary is liquidity danger, which materializes when too many traders redeem their shares concurrently. This danger is especially critical for hedge funds holding comparatively illiquid property. Underneath a excessive redemption situation, the fund could should promote its most liquid, highest-quality property first, leaving the remaining traders with a much less worthwhile portfolio, resulting in extra redemptions.
Underneath one other situation, the supervisor could freeze redemptions to stop a liquidation spiral. Hedge funds usually cut back liquidity danger by imposing an preliminary lock-up interval. Whereas such restrictions hamper traders’ potential to eliminate their funding at will, Aiken et al. (2020) counsel hedge funds with a lock-up are inclined to outperform attributable to their greater 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 12Â hedge fund indices reviewed and 58Â of the 72Â particular person funds labeled as inefficient on a stand-alone foundation can produce an environment friendly payoff profile when blended with the S&PÂ 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 greater Sharpe Ratios, data ratios, and alphas than their rivals. In different phrases, low-correlation hedge funds are inclined to ship greater risk-adjusted returns.
Bollen (2013) additionally checked out low R-squared hedge funds and got here to a special conclusion. He constructed giant 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 reliable diversifiers, however investing in such a 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 stage 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 attributable to their dependable diversification advantages.
Past Conventional Threat Measures
Analysis reveals that hedge funds may help diversify portfolios. Nonetheless, traders mustn’t oversimplify the difficulty. First, conventional danger measures like commonplace deviation and correlation are incomplete. Skewness and kurtosis have to be measured or estimated not directly. Merchandise with low historic commonplace deviation could disguise the opportunity of occasional excessive losses or a damaging anticipated return. Traders should totally perceive the fund’s funding technique and the way it could behave below adversarial circumstances. Traders should additionally mirror on what danger means below 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 reliable 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 all the time seize the complete image — skewness, kurtosis, and tail-risk publicity are essential concerns.
My remaining put up on this collection will clarify why I don’t advocate hedge funds.
