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Just how risky are hedge funds?

When speaking with fellow investors and finance professionals, I am surprised by how often I am told that hedge funds are more risky than equities. This article offers thoughts on why I think this belief is largely incorrect.

It is not possible to say categorically that hedge funds are more risky than equities or not, because the hedge fund universe is heterogeneous and different funds run different levels of risk that could be above or below that of equities. In my experience however, the majority of hedge funds run levels of risk that are far below that of equities, using most definitions of risk.

What risk is being measured?

It is also important to define ‘risk’ and how it can be measured. Most risk measures are based on historical returns and don’t say much about the actual risk that was taken to produce the observed return. A one dimensional number based on historical performance (such as return or volatility) only takes account of the single outcome instead of the range of possible outcomes that could have occurred. To put it another way, an asset that generated a positive return was not necessarily less risky than another asset that generated a negative return over the same period.

We prefer to take a multi-dimensional view of risk and find it counter-productive to reduce risk to a single number. The main risk faced by investors is the permanent impairment of capital and this is what we aim to protect against. Although it is beyond the scope of this short article, hedge funds are subject to a different set of risks (as a result of using leverage and shorting for example), which are not easily comparable to long-only managers. That said, just because a hedge fund uses leverage or sells short doesn’t automatically make it riskier than equities. In most cases the managers use these techniques to reduce rather than increase risk.

The perception of large hedge fund losses is almost certainly due to negative press coverage of a very limited number of failures or frauds. These extreme examples were typically avoided by the more astute hedge funds and are not consistent with our history of investing in hedge funds. Of course, if an investor had too high a percentage of their portfolio in any vehicle that failed it would be devastating, but to extrapolate that specific experience to the entire universe is like refusing to invest in equities because HIH Insurance failed.

This article compares the performance of the Ibbotson Alpha Strategies Trust, which is an actual portfolio of hedge funds (Hedge Fund Portfolio) after all fees, against the S&P/ASX 200 Accumulation Index (ASX 200) which is fee-free and outperforms the average long-only manager. This removes the impact of survivorship bias and other factors that are often cited as providing an artificial boost to the hedge fund indices, and also gives a slight boost to the equity portfolio.

Different methods of examining losing periods

Figure 1 is a drawdown chart, which shows the total losses sustained by the Hedge Fund Portfolio and the ASX 200 since the launch of the Hedge Fund Portfolio in late 2007. During the GFC, the Hedge Fund Portfolio lost a little over 18% whilst the ASX 200 lost 47%. If you consider capital loss as a measure of risk, the Hedge Fund Portfolio has been substantially less risky than the ASX 200 during all losing periods for the ASX 200.

Figure 1: Drawdowns for the Hedge Fund Portfolio and ASX 200 since October 2007

Minimising capital losses is crucial for any investor. It leaves a larger pool of capital to generate future returns. From the GFC low, the Hedge Fund Portfolio recovered its losses in 21 months whilst the ASX 200 took almost three times as long, 55 months, despite the ASX 200 having a far higher average return over the period (and the ASX 200 Price Index remains more than 20% below its 2007 high after more than eight years). If you consider time to recover your losses as an important risk, the Hedge Fund Portfolio was substantially less risky than the ASX 200.

Figure 2 looks at performance during difficult periods in another way, by comparing the performance of the Hedge Fund Portfolio to the ASX 200 during the 10 worst months for the ASX 200 since late 2007. The graph shows that the median loss for the ASX 200 over this time period was 7% whilst the median loss for the Hedge Fund Portfolio was around 1%.

Figure 2. Performance of the Hedge Fund Portfolio and the ASX 200 during the 10 most difficult months for the ASX 200

Returns and volatility since 2007

Although we don’t think that realised volatility is a very useful measure of risk in isolation, it has gained widespread acceptance. Figure 3 shows the Hedge Fund Portfolio has returned more than three times as much as the ASX 200 with one third of the volatility. On the basis of realised volatility, the Hedge Fund Portfolio has been a substantially less risky investment than the ASX 200. Figure 4 shows the value of $100 invested in late 2007, with the Hedge Fund Portfolio far more consistent.

Another observation is that the goal of fee minimisation without taking account of the actual investment outcome is narrow-minded. An investment in a low-fee ASX 200 tracker has experienced lower and more volatile returns.

Figure 3: Return and Volatility

Figure 4: Value of $100 invested at inception

The purpose of this article is to counter the commonly held belief that ‘hedge funds’ are riskier than ‘equities’. Although we believe the key risk that investors face is the permanent impairment of capital, we included a number of popular risk proxies including drawdown, performance during difficult months and volatility. We believe investors and financial advisers should consider the role and benefits that an allocation to hedge funds can play in a diversified investment portfolio.

 

Craig Stanford is Head of Alternative Investments with Morningstar Investment Management Australia Limited. The information provided is for general use only. Morningstar warns that (a) Morningstar has not considered any individual person’s objectives, financial situation or particular needs, and (b) individuals should seek advice and consider whether the advice is appropriate in light of their goals, objectives and current situation.

 

10 Comments
M Armitage
May 06, 2016

Craig nice article and wish you guys continued success. Australia, in comparison to the rest of the world has historically shown better active management performance. For many active managers it is not surprising to outperform a cap weighted benchmark. For example, small cap tilts, momentum filters, leverage et al. can add to an 'alpha' but they do introduce other risks beyond price volatility (as you highlight).
While there is no argument on which performance is preferential in the comparison you have shown, the question is are there better benchmarks to compare hedge fund performance against?

For example, in the US S&P 500 risk controlled benchmarks that utilise simple - transparent rules that manage net exposure dynamically provide similar or superior risk adjusted returns than hedge fund performance whilst avoiding the opaqueness and high fee environment of hedge funds.
Locally, managers have adopted similar rules based approaches to manage exposure directly without the historically high fee structures.

Craig Stanford
May 09, 2016

Thanks M Armitage,

Absolutely, there are more appropriate benchmarks and I wouldn't suggest that a long only equity index should be used to directly compare the performance of hedge funds against - I am only using it in this example to refute the notion that hedge funds are more risky than equities.

Roger Farquhar
May 06, 2016

For me the problem is which hedge (or managed) fund to choose? According to S+P Dow Jones 76% of funds failed to beat the ASX 200.

A while ago Canstar surveyed fund performance and found that over time their performance averaged out.

S+P "There is no consistent trend in the yearly active versus index figures, but we have consistently observed that the majority of Australian active funds in most categories fail to beat the comparable benchmark indices over three- and five- year horizons."

No wonder investors are chasing bricks and mortar.

Craig Stanford
May 09, 2016

Roger, I don't think you are alone in that regard - it isn't easy but it is possible. There are a small number of managers who have shown an ability to outperform over time.

Craig Stanford
May 05, 2016

Although it may seem convenient, the use of 2007 is really not cherry picking - it is the launch date of the fund used in the example. If I was to use the performance of another well managed fund of hedge funds with a longer track record I have no doubt that the difference would be even more stark in favour of the hedge fund portfolio on both an absolute and relative basis.

True, 2008 was particularly difficult for equities but it was also the most difficult period for hedge funds on record. In fact, this particular fund launched straight into a very difficult period for hedge funds in late 2007 that was dubbed the 2007 quant meltdown (or something along those lines).

On the fee front, those returns (3x equities with 1/3 of the volatility) are quoted after all fees (two layers of them - this is a fund of hedge funds) and the product still outperformed equities on an absolute and relative basis. It also produced those returns with an equity beta of less than 0.2 so there is a lot of alpha there if you measure it by conventional means.

As an investor in hedge funds, would I like to pay lower fees - for sure. But what I think is more important is trying to judge the relationship between the fees paid and the performance outcome to make sure it is balanced appropriately. Hedge funds in aggregate may charge more than long only or index managers but the good hedge fund managers more than earn that back for their clients by participating in the good times while also protecting capital against market declines and this is a key component of building wealth over time.

Jerome Lander
May 05, 2016

There are hedge funds with reasonable fees out there that I know. Not everyone charges high fees.

It is like everything. You need to choose the better options and these are quite often not the big brand names that everyone knows. Although some hedge fund investors just aren't open minded when it comes to considering new and better managers - that is their clients' loss and ultimately reflected in their performance. More open minded hedge fund investors could and should have done massively better than Australian equities in recent times.

Steven
May 05, 2016

Using 2007 as the starting point for the returns period is cherry picking. On the flip side, hedge fund haters cite the massive underperformance against the S&P 500 since 2009. Using either of those statistics to run an argument is biased.

The common saying that hedge funds are a compensation scheme masquerading as an asset class sums up the major problem. They may be less volatile, but the alpha versus equities (if any) is often more than consumed by the 2 and 20 fees. If they were run at a reasonable fee level, like 0.2 and 20 with a fair benchmark then there would be a lot more take up.

Jerome Lander
May 05, 2016

The biggest risk most investors currently face and usually face is their exposure to market risk and the risk of a large sell-off in broader markets causing a large and potentially permanent loss of investment capital. I would argue this risk is almost as big as ever currently because we have ridiculous monetary policy settings by central banks worldwide, creating significant mis-allocation of capital and valuation distortions. Low interest rates are not and will not fix the economic challenges we face, and very little has been done since the GFC to address the real underlying issues.

Thoughtful investors hence typically need to reduce and diversify their market risk. A critical thing investors can do to reduce their market risk is to invest more actively and with more active managers. Investing actively in order to reduce market risk and make a return - that is best done in a good hedge fund structure ("hedges" the market risk!).

Investors can reduce their risk of the odd bad apple by doing their due diligence or paying someone to do it for them. A fund closing and returning its money to you because it can't make the business work is not a great failure for the investor, unless it loses you money.

I'd also suggest avoiding those with long term track records of mediocre performance. Why on earth would you invest with someone who has demonstrated over a long period of time that they can't add much value? (a proven lack of skill) - that is one of the biggest mistakes investors make.

But the biggest mistake currently is thinking that you're safe by investing in the broader market. You are anything but.

Gary M
May 05, 2016

Most investors see hedge funds as “risky” because they are largely opaque obscure processes that by definition don’t fully reveal what they are doing. They could be the next Bernie Madoff. Something like 10% or more of all hedge funds fail and close down every year, so that makes them “risky”, notwithstanding how individual funds might perform.

Craig Stanford
May 05, 2016

Thanks for your comments Gary M

One of the points I raise in the article is that I believe the overwhelmingly negative public perception of hedge funds is largely due to a small number of failures or frauds that people outside the hedge fund industry believe is actually representative of the industry when in fact it is not. Madoff is a case in point and is a great example of a fund which was avoided by the more astute investors.

Disclosure levels vary across the industry and the investor is free to decide if what they receive is sufficient for their needs. If we aren't comfortable with the information we get we don’t invest but to suggest that all hedge funds are opaque and obscure is simply not accurate. Disclosure has in general increased across the industry and as an active hedge fund investor I am very comfortable with the level of disclosure we receive from both existing and potential managers. The level of regulation on hedge funds has increased exponentially over the years; a publicly visible example of which would include any institutional investment manager that manages over $100m of qualifying assets has to report their holdings to the US SEC on a quarterly basis – and this information is made public.

The number of hedge fund closures you cite is accurate but you shouldn't confuse closures with funds that lose money, and more specifically large amounts of money for their investors – the vast majority of closures are because the fund does not raise sufficient assets to reach scale so the money is returned to investors – incidentally, this often occurs when the fund has actually generated profits.

 

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