A Demystification Of Hedge Funds and The Risk For Investors

September 26, 2014

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited a DIFC asset manager specializing in Hedge Fund management.

As investors in the GCC become increasingly sophisticated and continue to institutionalize there have been pioneers, early adopters and latecomers in the development of an alternatives (hedge funds) portfolio. The regions pioneers have been the sovereign wealth funds, with ADIA as the worlds largest single investor in hedge funds. Some large and sophisticated family offices have followed the prudent lead of the Sovereign Wealth Funds along with a handful of corporates, foundations and wealth management firms but regional allocations to the asset class still ominously lag their western peers at a time when the worlds institutional investors are increasing their hedge fund allocations.

Why sophisticated investors are selecting hedge funds?

The year 2014, which we previously proposed would be the year of the hedge fund is already seeing large flows into the asset class and in 2015, the industry may manage more than $3.3 trillion according to a report by Boston Consulting Group. The forces compelling inflows today are the same as those driving flows to hedge funds historically they are primarily related to risk management.

10-15 years ago, the impetus to invest in hedge funds was to diversify overweight allocations to equities as valuations were historically high and expected returns withered. Hedge funds provided uncorrelated returns that were expected to mitigate exposure to expected market downturns. Historically, hedge funds best relative performance was generated when markets faired poorly. Investors seeking to protect gains from the equity bull market of the 90s sought hedge funds to manage risk and protect their downside.

Today, expensive bond markets combined with increasingly dear equity valuations create a similar yet in some ways starker backdrop as expected future returns on stocks and bonds fall in step. Inflows and allocations to hedge funds are therefore likely to be best explained by investors seeking to protect their downside as uncertainty grows amid expensive stock and bond markets.

Risk Matters

Risk is often defined as volatility, but it is certainly not perceived this way by private investors. The probability of losses, particularly large losses, is a more pragmatic definition of risk for the individual investor as losses destroy the rate at which capital compounds. To maintain a portfolio with long run growth, investors must achieve positive return asymmetry this is where hedge funds excel.

Asymmetric Returns

A marketing phrase often used by hedge funds is that hedge funds produce equity-like returns on the upside and bond-like returns on the downside. This statement may be an exaggeration and oversimplification, but it is not entirely untrue based on historical performance of hedge fund indices. Hedge funds typically generate more modest returns during protracted equity bull markets, but outperform strongly during bear markets delivering a long-run return profile that is more positively asymmetric than the market index.

The key to maintaining superior long-term returns and positive compounding is positive asymmetry, which is achieved through robust risk management and avoidance of significant losses, as losses destroy the rate at which capital compounds. Positive asymmetry is where hedge funds have delivered for investors by reducing the relative downside investors inevitably experience as financial markets ebb and flow. The end result is relative outperformance by hedge fund indices on both a risk adjusted an absolute basis compared with major equity indices, such as the S&P 500.

Risk Management

Hedge funds typically manage risk based on the premise that superior long run returns can be generated through strategic selection of assets. Most hedge funds seeks to buy assets that they believe will outperform the market and sell/short assets they will believe will underperform. Short positions and derivatives held by many hedge funds might be considered on a standalone basis to be risky and speculative, but as part of a typical hedge fund portfolio these assets serve to offer protection or a hedge against market downturns or volatility often reducing risk for investors.

Empirical evidence demonstrates the effectiveness of this approach with Hedge Fund indices posting long run out performance on both an absolute and a risk adjusted basis when compared to most market indices and other asset classes. By reducing market correlation and mitigating downside risk hedge funds have emerged as an essential component of the prudent investors portfolio.