Does your hedge fund umbrella work in the rain?

Date: Tuesday, November 14, 2006
Author: Fatima Vadwa, Busrep.co.za

The case for hedge funds is a strong one. The upside of broader mandates, strategy diversification, risk reduction, downside protection and yield 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 unit of risk. In the Sharpe ratio, the unit of risk measured is the standard deviation.

So where is the downside?

One important theme, raised by international hedge fund researcher Harry Kat, is that hedge funds may reduce standard deviation, but at the expense of skewness. (Skewness measures the probability of an unusual event, such as 9/11, influencing your returns in one direction or the other.)

A distribution that is negatively skewed has a higher probability of large negative returns.

Two things compound this problem. First, the most popular measure of risk, the standard deviation, is insensitive to skewness. Two funds can have the same standard deviation, but one of the funds can have a much greater probability of large losses.

Second, Kat showed that many hedge funds show co-skewness with typical investment portfolios. This is a big problem: it means your hedge fund, chosen as a risk diversifier, may crash at the same time as the rest of your portfolio.

Suppose you add an equity market-neutral fund to your portfolio. Such funds will provide a useful addition, adding return but displaying a low correlation with the rest of your long-only equity portfolio. That's attractive. But suppose your hedge fund works by going long illiquid, small-cap stocks and short 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 battalions. Something like this happened after the 1998 crash. Although hedge funds were not much in evidence then, there were many small-company funds that had been star performers prior to the crash but struggled for many years thereafter, until relief arrived with falling interest rates in the early 2000s.

What to do? The answer is simple: be aware; be intelligent.

Be aware. With any investment, you should know under what circumstances it will underperform. You should know what factors your investment is exposed to. In the example above, a good risk analyst would easily identify the exposure to liquidity and size factors in the portfolio. And good fund of hedge fund 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 you require. Researchers at French institute Edhec have shown that hedge funds differ in the degree of co-skewness they exhibit with various traditional portfolios. Certain styles of hedge funds make good diversifiers of long equity portfolios under all market conditions. Some don't.

A good fund of funds manager will ensure a high proportion of such rainproof umbrellas in your portfolio.

Where the optimisation is quantitative, the use of a risk measure sensitive to skewness will ensure that skewness is minimised. If the optimisation is carried out at the level of the total portfolio, the co-skewness effects will be dealt with.

If you do those things, you will end up with an umbrella well worth the price.