Common Misconceptions About The Risk Associated With Hedge Funds

One of the top reasons that investors and financial advisors don’t invest in hedge funds is that they think they are too risky. As with any investment, there is a certain amount of risk associated with hedge funds and yes, the risk is greater than that of t-bills or government bonds. However, one could argue that the investment strategies of hedge funds are less risky than that of a long-only portfolio of stocks.

To say that hedge funds are risky without elaborating on “how they are risky” is unfair and a half-truth. Is it the strategies that are risky or is it the fund that is risky? There is a big difference between those two statements.

In an article published in the Fall 2006 issue of the Journal of Alternative Investments, Corentin Christory, Stephane Daul and Jean-Rene Giraud published their findings on why hedge funds default. The trio looked at 109 cases from 1994-2005 where hedge funds had gone under. They broke the reasons down into three categories—fraud, financial losses and operational. The results showed that 54% of failures involved fraud, 33% involved financial losses and 13% were due to operational issues.

Looking at the cases of fraud and operational issues, we see that 67% of defaults came from these two areas and only a third came from financial losses. Defaults due to financial losses are the funds where the trading results led to the fund folding. These results are why you have to distinguish between operational risks (the fund managers) versus investment risks (the strategy).

The reality is that when a fund goes under due to fraud, these are the stories that make the mainstream headlines. Very rarely do you read about a fund going under when it as due to the investment strategy. It should also be pointed out that during the years the defaults occurred (1994-2005), there was tremendous growth in the number of funds in operation. According to the article, there were 751 funds available in 1994 and that number grew to 5,563 in 2005.

During this growth phase, the percentage of funds that went into default never reached higher than 0.5% in any given year. In 1998, there were 10 funds that closed and there were 1,917 funds available. That tied for the highest percentage of funds to close with the year 2001 when 18 funds closed and there were 3,635 funds available. Conversely, the lowest percentage of fund closings came in 1999 when only two funds closed up shop and there were 2,430 funds available. Extrapolating these numbers out, during the years in question, the default rate ranged from 0.2% to 0.5%. With over 10,000 funds available now, the expected default rate would translate to between 20 and 50 funds closing their doors this year.

If we look at the percentages of funds that closed due to fraud (54%), financial loss (33%) and operational issues (13%) and apply those to today’s numbers, we can get a reasonable expectation for default rates in today’s environment. you would have the following expectancy rates for fund closures:

  • Fraud- between 10.8 and 27 funds would close as a result of fraud
  • Financial loss- between 6.6 and 16.5 funds would close as a result of financial loss
  • Operational issues- between 2.6 and 6.5 funds would close as a result of operational issues

As you can see, the odds of being invested in a fund that goes out of business are relatively small. It should also be pointed out that if a hedge fund goes out of business, investors don’t necessarily lose all of their investment. In the case of fraud, it is possible that anyone invested in the fund will lose all or most of their investment. In the case of financial loss or operational issues, those invested in the fund should get some portion of their investment back and they could potentially get all of their investment back.

There are a couple of points to be made here. First, when people say that hedge funds are risky, they may not mean that hedge fund strategies are risky, they may be referring to the risk of default. Which we learned isn’t that common of an occurrence based on the numbers above. Secondly, the risk of default can be removed. With HedgeCoVest, you are replicating a hedge fund’s strategy. You are not investing directly in a hedge fund. Because of the structure, the investor’s money is never in the direct control of the hedge fund manager which eliminates the risk of losing money as a result of fraud. The investment risk is still there, but even then the investor is in control and can liquidate the investments that were entered into by following a certain fund strategy.

A long-short fund or market neutral fund should prove to be less risky than a portfolio of stocks that are not hedged. Based on the performance of the various hedge fund indices, hedge funds usually trail the market during prolonged bullish periods, but they usually perform better than the overall market during a bearish period. Does that sound like a risky strategy to you?

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