AIMA
The Alternative Investment Management Association
Welcome to AIMA
Alternative Investment Management Association
Does your hedge fund umbrella work in the rain?
Fatima Vawda
Legae Capital
2007
The case for hedge funds is a strong one. Many investors, including increasing numbers of institutional investors, have opted for hedge funds as a diversificationGenerally refers to the variety of investments in a fund's portfolio. Risk-averse fund managers seek to combine investments that are unlikely to all move in the same direction at the same time. element in their traditional portfolios. The upside of broader mandates, strategyThe particular investment process employed by a manager in the application of an investment style. diversificationGenerally refers to the variety of investments in a fund's portfolio. Risk-averse fund managers seek to combine investments that are unlikely to all move in the same direction at the same time., riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR). reduction. Downside protection and yieldThe return earned on an investment with the annual income and present capital value taken into account. enhancement offered by hedge funds, has been too attractive to ignore.
Research has shown that the appropriate addition of a hedge fund component increases the Sharpe ratio of a fund; that is, it increases the ratio of excess returns per unitA generic term used to describe the 'instrument' (share, bond, loan note, participation interest, etc.) which is issued by a product. Investors invest in a product by subscribing for units and can also redeem their units at the prevailing net asset value per unit, as detailed in the relevant product prospectus. of riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR).. In the Sharpe ratio the unitA generic term used to describe the 'instrument' (share, bond, loan note, participation interest, etc.) which is issued by a product. Investors invest in a product by subscribing for units and can also redeem their units at the prevailing net asset value per unit, as detailed in the relevant product prospectus. of riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR). measured is the standard deviationFor an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation..
So where is the downside?
One important theme, raised by international hedge fund researcher Harry Kat and others is that hedge funds may reduce standard deviationFor an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation. but at the expense of skewness (and in particular, negative skewness). A distribution which is negatively skewed is one which has a higher-than-normal probability of large negative returns. Clearly this is a kind of riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR). that matters to us. Large losses pose very difficult challenges for the investorSee Eligible investor. See Accredited investor. Investors in hedge funds can be categorised in many ways but the most clear distinction is between fund of hedge funds managers and direct investors: 1. Fund of hedge funds managers: These entities manage diversified portfolios of hedge funds (usually in the form of collective investment schemes), and provide their investors with services such as fund selection and risk management in return for a fee. 2. Direct investors: Hedge funds are aimed primarily at institutional and sophisticated investors. Direct investors include pension funds (public and private), endowments, foundations and family offices. and the portfolio managerA company or individual that runs capital on behalf of an investment fund, such as a hedge fund. The portfolio manager is often the general partner of the fund's limited partnership. It may be an employee of the fund management firm, or an external entity with which the hedge fund makes a passive investment..
Two things compound this problem. One is that the most popular measure of riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR)., the standard deviationFor an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation. (as used in the Sharpe ratio), is insensitive to skewness. Two funds can have the same standard deviationFor an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation. but one of the funds can have a much greater probability of large losses.
Another issue that Kat also showed is that many hedge funds display co-skewness with typical investment portfolios. This is a serious problem. It means that your hedge fund, chosen as a diversifier of riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR)., may crash at exactly the same time as the rest of your portfolio does.
Here is an example. Suppose you add an equityThe net worth of a company. This represents the ownership interest of the shareholders (common and preferred) of a company. For this reason, shares are often known as equities. market-neutral hedge fund to your portfolio. Such funds will, under most circumstances, provide a very useful addition, adding return but displaying a low correlation with the rest of your long-only equityThe net worth of a company. This represents the ownership interest of the shareholders (common and preferred) of a company. For this reason, shares are often known as equities. portfolio. That is very attractive. But suppose that your hedge fund works entirely by going long illiquid, small-cap stocks and shorting liquid large caps.
Historical evidence shows that such funds take a beating at times of market crashes because of the subsequent flight-to-quality as investors ditch small illiquids for the safety of the big battalions. Something like this happened after the 1998 crash. Although hedge funds were not much in evidence then, there were many small-company funds which had been star performers prior to the crash but which struggled for many years thereafter, until relief arrived in the form of falling interest rates in the early 2000s.
So, what to do? As is so often the case, the answer is simple. Be aware. Be intelligent.
Be aware. With any investment, you should know under what circumstances that investment will underperform. In particular, you should know what factors your investment is exposed to. In the example above, a good riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR). analyst would easily identify the exposureThe extent to which a hedge fund is vulnerable to changes in a given financial market. Exposure can be measured on a net or gross basis. See Gross exposure. See Net exposure. to liquidityThe ease with which an investment product/fund can be sold/redeemed from, without impacting its price. Hedge funds typically offer quarterly or annual liquidity, meaning that they allow investors to redeem their shares that often. and size factors in the portfolio. Good fund of hedge funds managers will ensure that undesired factor exposures are minimised at the overall fund level.
Be intelligent. Construct your hedge fund portfolio so that it has the properties that you require. Researchers at the French institute Edhec have shown clearly that hedge funds differ in the degree of co-skewness they exhibit with various traditional portfolios. Certain styles of hedge funds make very good diversifiers of long equityThe net worth of a company. This represents the ownership interest of the shareholders (common and preferred) of a company. For this reason, shares are often known as equities. portfolios, under all market conditions. Some do not. A good fund of funds managerManager of a fund that invests in a series of hedge funds. The portfolio will typically diversify across a variety of investment managers, investment strategies and subcategories. will ensure a high proportion of such “rain-proof umbrellas” in your hedge fund portfolio and make sure that the overall portfolio has just the right characteristics to optimise your total portfolio. Where the optimisation is quantitative, the use of a riskSee Downside risk. See Event risk. See Liquidity risk. See Market risk. See Systemic risk. See Systematic risk. See Operational risk. See Unsystematic risk/unique risk. See Value-at-Risk (VaR). measure sensitive to skewness, such as VaR or expected tail loss, will ensure that skewness is minimised. If the optimisation is carried out at the level of the total portfolio (i.e. traditional and alternative together) the co-skewness effects will also be dealt with.
