Alternative Investment Management Association Representing the global hedge fund industry
As more and more market participants make the leap further and further into alternative investments, it is paramount that they understand what to expect going forward and what types of new risks they may need to be aware of. Unfortunately for many investors, promises of uncorrelated returns have been hard to come by and investors are scratching their heads wondering what to do next.
Diversification and alpha beta separation
If we go back to founding principles in the alternative space, we can outline the paradigms which ground investment decisions we see today. Going back to basics, portfolio management is about diversification and balancing risk and reward. Similar to CAPM theory, diversification works because as you add more and more uncorrelated or less correlated assets the idiosyncratic or diversifiable risks can be reduced. Balancing risk and reward requires investors to allocate to a set of risk factors while attempting to maximize their return given a prescribed level of risk. The alpha beta separation suggests that investment strategies can be divided into alpha and beta drivers. Returns from alpha drivers are focused on absolute return with hedged systemic risks. On the other hand, beta drivers are about earning risk premiums with exposure to systematic risk. Absolute return strategies, given their tantalizing moniker, fit perfectly into this strategy where in the modern days of portfolio allocation, systematic risks can be accessed cheaply while absolute return vehicles can pump up total return with “seemingly” little impact on total risk.
Send in the tails
Most alternative investment strategies use carefully constructed investment strategies which, often but not always, involve leverage. They invest in assets with varying levels of liquidity and sometimes complex networks of counterparties including both their brokers and fund investors themselves. Each and or any of these characteristics can catch normally very solvent and well thought out strategies in the heat of the moment and especially during a moment of financial crisis. This structural set-up for hedge funds makes risks in hedge funds increasingly more about tail risk.
Recent research in hedge funds in crises demonstrates that many hedge funds are holding common latent idiosyncratic risks in credit, liquidity, and volatility (see Billio, Getmanksy and Pelizzon 2010). These risks may be linked to issues related to liquidity, complex counterparty network effects, funding liquidity, rapid redemptions, and margin death spirals. As most risk measurement techniques are based on divergent approaches unfocused on structural issues, they may miss these potential risks. This point highlights the fact that, just like the term hedge, hedge fund risks are more about “magnified basis risks” and/or tail risks. These risks, if not properly accounted for, can result in a lack of diversification and a lack of alpha beta separation. Put simply, naïve diversification in the alternative space can lead to increased idiosyncratic risks while tail risks may deem so called absolute return strategies less than absolute.
Where are you holding your tail?
Lackluster performance in many alternative strategies has sent this message to investors. The only remaining question investors are asking is what to do about tail risks? The key of course, is in going back to basics. If you really want diversification in your portfolio, find investments that like crisis and volatility. Investors need to focus on deciding if they want to pay insurance premiums for the next financial apocalypse or try to find alternative strategies which may be able to deliver “crisis alpha” when their portfolios truly need it.
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