Sources of Risk, Return, and Diversification among Hedge Fund Investments

Hedge funds function as investment vehicles designed to minimize market exposure and returns derived from beta, emphasizing the generation of idiosyncratic returns. The primary source of excess return in hedge funds comes from exploiting market inefficiencies, which could be fleeting, and the manager’s skill in leveraging these inefficiencies.

For example, a hedge fund manager might identify an undervalued stock caused by a momentary market overreaction and heavily invest in it, creating alpha as the market rectifies itself.

Sources of Hedge Fund Performance

Hedge fund performance can be ascribed to three sources:

• Market beta: This constitutes the overall market beta achievable through market index-based funds or ETFs.
• Strategy beta: This is the beta associated with the hedge fund’s investment strategy deployed within the broad market.
• Alpha: These are the manager-specific returns due to the selection of specific positions.

Managers leverage their expertise in identifying mispriced securities and sectors, accurately timing the market, and exercising operational control over the company’s business model to capture strategy beta and alpha returns. They can also use leverage to amplify the outcomes.

Traditional Asset Pricing Models

Conventional asset pricing models function based on a series of assumptions, including the assumption of market efficiency. Hedge fund returns stem from systematic and idiosyncratic alternative risk factors that these models do not account for.

For example, a hedge fund might generate returns from exploiting pricing inefficiencies in the market, which would not be captured by a traditional asset pricing model that assumes market efficiency.

Investor Returns and Hedge Fund Fees

Generally, investors often do not fully capture the returns yielded by hedge funds. Hedge funds are recognized for their elevated fees, which diminish the alpha they generate. For instance, a hedge fund might impose a 2% management fee and a 20% performance fee, leading to a substantial portion of the fund’s returns being allocated to fees.

Additionally, when capital is redeemed from liquidated positions, it may lead to a reduced payout, thereby decreasing the overall return from the fund. If a hedge fund has to vend assets at a loss to fulfill redemption demands, this could further lower the fund’s returns.

Challenges in Assessing Hedge Hedge Risk-Adjusted Returns

To assess the risk-adjusted returns of individual hedge funds and collective hedge fund strategies, hedge fund indexes are employed. These indexes are formulated using publicly accessible hedge fund performance data.

The majority of hedge fund indexes rely on information reported voluntarily by hedge fund managers and other authorized recipients of performance data. This voluntary reporting introduces various biases, indicating that hedge fund performance is probably overestimated.

These indexes may encounter selection bias, wherein individual funds are placed into strategy peer groups in an irregular fashion. This allocation might rely on the prospectus in some cases, historical style analysis in others, or a combination of approaches. Moreover, indexes may also draw from inconsistent sources of the underlying data.

Fund indexes may face survivorship bias, where funds that have stopped reporting are excluded from the index, potentially leading to an inflated depiction of performance. To mitigate this bias, incorporating the returns of both active funds and those that have ceased reporting can be instrumental.

Moreover, hedge funds that have closed to new investors or ceased operations because of subpar performance are treated similarly; their performance is omitted from the index value.

Additionally, it’s crucial to acknowledge that hedge fund performance data is commonly released with a delay, often around four weeks or one month. Due to the non-investable and illiquid nature of these indexes, replicating their performance can pose a challenge.

Another potential concern is backfill bias. This occurs when a successful fund commences reporting its performance for the first time, and its prior strong performance is added to the index. This may result in an exaggeration of the index’s actual performance. This situation resembles survivorship bias, occurring when a new hedge fund is integrated into an index and its historical performance is retroactively added “backfilled” into the index’s database.

Lastly, most hedge fund indexes do not weight funds by assets under management. In these indexes, each hedge fund is given an equal index weighting in the performance peer group. This can result in skewed comparisons between large and small funds compared to the performance of a size-weighted index.

Hedge Fund Investment Risks and Returns

In traditional investments, funds such as index ETFs tend to diversify away a significant portion of idiosyncratic risks by investing in numerous stocks and earning their return by bearing the systematic risk, also called beta. On the other hand, hedge funds utilize various instruments across asset classes and methods, with an aim to earn absolute returns under all market environments.

Hedge Fund Benchmarking

Hedge fund managers have a high degree of flexibility over investments and offer minimal disclosure, making it difficult to conduct performance attribution analysis. For example, a hedge fund might invest in private equity, real estate, commodities, and other non-traditional assets, and it might not disclose these investments until much later.

The relative illiquidity of investments held by the funds makes marking to market a problematic and potentially futile process. Therefore, attributing the sources of returns and risks is a composite process that is further complicated by the complexity of the strategies and compounded using various sources of leverage.

As such, risk and return comparisons are typically made to fund-of-funds composite indexes to minimize return distortions. This approach controls for the effects of self-reporting and selection biases and ensures that the fund-of-funds benchmark index is investable.

Examples of hedge fund indices include the HFRI Fund of Funds Composite Index, the MSCI ACWI Index, and the Bloomberg Barclays Global Aggregate Index.

Hedge Fund Strategies Performance

Assessing the performance of diverse hedge fund strategies across time involves considering the connection between hedge fund returns and risk, typically measured by the standard deviation of returns. For instance, strategies like short-bias and betting on stock price declines have demonstrated lower performance compared to all other strategies in both return and standard deviation-based risk. Numerous hedge fund strategies exhibit notably different risk and return features when contrasted with typical equity and fixed-income benchmarks.

The risk-return tradeoff of hedge fund investment is also measured using the coefficient of variation of annual hedge fund returns. The coefficient of variation can be seen as the price of return relative to risk. Intuitively, a higher coefficient of variation indicates a greater return for the same amount of risk.

Diversification Benefits of Hedge Fund Investments

Hedge funds present opportunities for risk diversification, but these advantages can vary. Therefore, investors need to be diligent in their selection of a hedge fund manager.

Typically, hedge fund performance shows minimal correlation with traditional asset classes like bonds and currencies/cash. This aspect makes hedge funds an appealing choice for conventional investors aiming for diversified portfolios and stable returns in the long term.

For instance, integrating hedge funds into a traditional 60/40 portfolio (60% stocks and 40% bonds) can lead to a decrease in the total portfolio standard deviation and an increase in the Sharpe ratio. This results in enhanced portfolio diversification and improved risk-adjusted return.

Question

An investor is considering diversifying his portfolio, which is primarily composed of stocks and bonds. He is considering adding a hedge fund to his portfolio. Based on the general characteristics of hedge funds, how might this decision potentially impact the overall risk of his portfolio and why?

1. The overall risk of the portfolio would increase due to the high correlation between hedge funds and traditional asset classes.
2. The overall risk of the portfolio would decrease due to the low correlation between hedge funds and traditional asset classes.
3. The overall risk of the portfolio would remain the same as hedge funds have no correlation with traditional asset classes.

The correct answer is B.

Adding a hedge fund to a portfolio primarily composed of stocks and bonds could potentially decrease the overall risk of the portfolio due to the low correlation between hedge funds and traditional asset classes. Hedge funds employ a variety of strategies, including short selling, leverage, arbitrage, derivatives, and other complex financial instruments, which can result in a low correlation with traditional asset classes such as stocks and bonds. This low correlation can provide diversification benefits, reducing the overall risk of the portfolio.

A is incorrect. Hedge funds do not necessarily have a high correlation with traditional asset classes. The strategies employed by hedge funds can result in a low correlation with traditional asset classes, providing diversification benefits and potentially reducing the overall risk of the portfolio.

C is incorrect. While it is true that some hedge fund strategies may have no correlation with traditional asset classes, it is not accurate to say that all hedge funds have no correlation with traditional asset classes. The correlation between hedge funds and traditional asset classes can vary depending on the specific strategies employed by the hedge fund. Therefore, adding a hedge fund to a portfolio could potentially impact the overall risk of the portfolio.