Hedge funds are often sold as high-return, low-correlated investments that can provide the benefits of diversification over traditional portfolios. However, investors must look beyond the marketing pitch to fully understand the risks involved. Leverage, short sales, and derivatives can introduce hidden vulnerabilities, while pricing structures promote strategies that generate steady profits, but sometimes expose investors to deep losses.
This post is the second in a three-part series examining the hedge fund literature to assess risk and potential diversification, providing insight into when and how it fits into your investment strategy. My first post shows that this study suggests that skills and alpha are difficult and difficult to obtain in the hedge fund market, especially among those listed in commercial databases.
Risks of hedge funds
Some hedge funds are extremely unstable due to the permission to use leverage, short sales and derivative product strategies. Their asymmetric fee structure encourages the adoption of investment strategies with negative outcomes and high kurtosis. In other words, many hedge funds tend to offer modest regular profits (probably generating performance fees) at the expense of deep losses from time to time.
Hedge funds using leverage also carry funding risks. This happens when the fund's major lenders stop funding, requiring the fund to find another lender or settle the assets to pay off the debt. Investors need to pay close attention to funding risks. Barth et al. (2023) report that almost half of hedge fund assets are liable for liabilities.
Another important thing is liquidity risk. This is achieved when there are too many investors and redeem the stocks at the same time. This risk is particularly severe for hedge funds that hold relatively illiquid assets. Under a high redemption scenario, the fund must first sell the most liquid and highest quality assets, leaving the remaining investors with a less valuable portfolio, leading to more redemption.
In another scenario, the manager can freeze the redemption to prevent liquidation. Hedge funds often reduce liquidity risk by imposing an early lockup period. Such restrictions hinder the ability of investors to dispose of their investments freely, but Aiken et al. (2020) suggests that hedge funds with lockups tend to outperform due to high exposure to anomalies that mimic stocks.
Characteristics of diversification
Research generally acknowledges the benefits of hedge funds' modest diversification. Amin and Kat (2009) found that seven out of 12 hedge fund indices were reviewed, and 58 out of 72 individual funds, classified as inefficient, could generate efficient payoff profiles when mixed with the S&P 500 index. Kang et al. (2010) found that the longer the investment period, the greater the benefits of diversifying hedge funds.
Titman and Tiu (2011) studied a comprehensive sample of hedge funds from six databases and concluded that lower R-square funds exhibit higher Sharp ratios, Information Ratios, and Alpha than their competitors. In other words, low-correlated hedge funds tend to offer higher risk-adjusted returns.
Bollen (2013) also looked at low R-squared hedge funds and came to another conclusion. He has built a large portfolio of multiple Zero R Square hedge funds. He discovers that these portfolios have up to half of the volatility of other hedge funds, suggesting that despite their appearance, zero R-squared hedge funds have considerable systematic risks. The authors also found that low R-squared properties increase the likelihood of fund failure.
Brown (2016) argues that hedge funds are legitimate diversification factors, but investing in this type of product without deep operational due diligence is completely dangerous. Newton et al. (2019) reviewed 5,500 North American hedge funds following 11 different strategies from 1995 to 2014. They report that six strategies “providing important and consistent diversification benefits to investors regardless of their level of risk aversion.” The four strategies offer more gradual benefits, and only one strategy does not improve portfolio diversification. Interestingly, their measure of diversification benefits explains skewness and kurtosis.
Finally, Bollen et al. (2021) found that despite a severe decline in performance since 2008, the allocation of 20% to hedge funds still reduces portfolio volatility, but fails to improve the Sharp ratio. They conclude that the benefits of reliable diversification could justify a modest allocation to hedge funds for risk averse investors.
Beyond traditional risk measures
Research shows that hedge funds can help diversify their portfolios. However, investors should not oversimplify the issue. First, traditional risk measurements Standard deviation and correlation are incomplete. Skewness and kurtosis must be measured or estimated in some way. Products with a low historical standard deviation can mask the possibility of occasional extreme losses or negative expected returns. Investors need to have a thorough understanding of the fund's investment strategy and how it behaves in disadvantaged circumstances. Investors should also reflect the meaning of risk under certain circumstances. Sacrificing the expected returns for diversification can damage financial health in the long term.
Key takeout
Hedge funds act as legal diversifiers, but blind allocations are dangerous. While certain strategies demonstrate the benefits of consistent diversification, they introduce risks of funding, liquidity and extreme loss that investors must carefully evaluate. Traditional risk measurements such as standard deviations and correlations do not always capture the big picture. Exposure to skewness, kurtosis, and tail risk are important considerations.
In my last post in this series I will explain why I don't recommend hedge funds.
