Identifying Hedge Fund Risk is Risky Business

We received an interesting question from one of our members earlier this week:

“I was wondering if someone could give me an idea of where hedge funds are on the totem pole as far as risk with intangible investments. My guess is that they rank with growth mutual funds and are less risky than stocks but I would like a more descriptive census of where they stand amongst stocks and mutual funds.”

Hedge funds are uniquely difficult to assign risk profiles because they employ many different strategies. Some hedge funds buy up illiquid assets when liquidity is at a premium, and these assets are selling at pennies on the dollar. In some situations, the fundamentals are still very sound, but the hedge funds are purchasing the assets at a deep discount further lowering the risk and raising the potential return on investment. When done properly, this strategy is low risk and similar to a corporate bond fund. Other hedge funds will invest in highly speculative strategies, specializing in risky assets like distressed debt and emerging market equities, or risky derivatives like commodity futures. These strategies tend to have risk profiles similar to investing in individual stocks, but better managers will be able to reduce risk and stabilize returns to a degree.

To develop an accurate risk profile for a specific hedge fund, investors need to gather as much information about the underlying assets and fund strategy as possible. Usually, investors only have access to the types of assets used, but increased transparency in hedge funds is the current trend, and hedge fund managers will probably start disclosing more and more information about their trading positions. For each strategy, certain levels of risk are inherent, and remember that leverage increases risk just like returns. While strategy will tell investors a lot about the hedge fund’s risk profile, implementation of the strategy is another important piece to hedge fund risk.

Therefore, investors have to develop a risk profile of the hedge fund manager. This profile should include information about the manager’s historical performance for all his funds, including statistical analysis that measure standard deviations, maximum drawdowns, downside deviations, and all the risk-adjusted return ratios like Sharpe and Sortino ratios. Particular attention must be paid to the hedge fund manager’s performance in similar strategies to the fund of interest. Investors need to identify how the fund manager performed when using a “low risk” strategy or a “high risk” strategy.

Lastly, investors need to inspect the fund’s infrastructure. Check to make sure the hedge fund is using high quality third party administration, legal advice, auditing services, and brokerage services. Performing due diligence on a fund’s infrastructure goes a long way towards identifying counter party risk and preventing fraud

I’m pretty sure my answer to the above question is a little more technical and in depth than what was asked for, but the point is that hedge funds can’t be fitted to neat little risk profiles or mutual fund style boxes. However, hedge funds were originally designed with the intention of preserving capital for the ultra-wealthy. Because the hedge fund manager ultimately has control of the fund and can utilize in style he deems appropriate, he is the key differentiator in measuring risks of hedge funds and risks of other investment vehicles. So, my short answer is hedge funds are as risky as the hedge fund manager wants them to be.

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