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 pitch, nevertheless, to totally perceive the dangers concerned. Leverage, brief promoting, and derivatives can introduce hidden vulnerabilities, whereas price buildings could encourage methods that generate regular good points however expose traders to occasional deep losses.
This submit is the second in a three-part sequence 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 submit, 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 business databases.
Hedge Fund Dangers
Because of the permitted use of leverage, brief promoting, and spinoff product methods, some hedge funds are extremely unstable. Their uneven price buildings 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 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 major lender ceases to supply financing, requiring the fund to search 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. Below a excessive redemption state of affairs, the fund could should 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 scale 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) recommend hedge funds with a lock-up are inclined to outperform as a result 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 categorized as inefficient on a stand-alone foundation can produce an environment friendly payoff profile when blended 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, info 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 writer additionally finds that the low R-squared property will increase the likelihood of fund failure.
Brown (2016) claims that hedge funds are official diversifiers, however investing in one of these 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 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 as a result of their dependable diversification advantages.
Past Conventional Threat Measures
Analysis exhibits that hedge funds can assist diversify portfolios. Nevertheless, traders mustn’t oversimplify the difficulty. First, conventional danger measures like customary deviation and correlation are incomplete. Skewness and kurtosis should be measured or estimated ultimately. Merchandise with low historic customary deviation could cover the potential of occasional excessive losses or a destructive anticipated return. Buyers should totally perceive the fund’s funding technique and the way it could behave beneath hostile circumstances. Buyers should additionally replicate 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 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 rigorously. Conventional danger measures like customary deviation and correlation don’t at all times seize the complete image — skewness, kurtosis, and tail-risk publicity are vital issues.
My last submit on this sequence will clarify why I don’t suggest hedge funds.
