Portfolio Risks and Hedge Funds

Portfolio Risks Portfolio construction is a mixture of art and science, using both sides of the brain to create superior portfolios. Analyzing how a portfolio will behave under various market conditions is essential to the construction of a risk-efficient portfolio. Investors need to define what risk-efficient means to them: minimum standard deviation, maximum Sharpe ratio, lowest possible loss, etc. In building a portfolio the risk of each investment should be analyzed in the context of the entire portfolio, constructed on an incremental basis. In the mean-variance framework, there is a trade-off between mean (reward) and variance (risk). Risk tolerance expresses the degree of loss an investor is willing to withstand in order to generate an expected return. To rank distributions and define risk, preferences must be introduced. Risk should always be considered simultaneously with the expected return. Always remember that baring risk is an essential component of investing, as long as an investor is adequately compensated for the risk they take. To manage risk, an investor needs to understand the sources of risk. At the highest level, there are systematic risks (risks that cannot be diversified away because they affect the entire market) and unsystematic risks (risks associated with specific companies). Risk management requires a decomposition of the particular risks and the ability to find potential hedges. A manager must be able to identify risks, control exposures and capitalize on opportunities. Managing investment risk is as much about exploiting fresh opportunities for gain as it is about avoiding losses. Risk budgeting is not about eliminating risk, but efficiently balancing risk and expected return.

Types of Risks Risks can be broken down into broad categories: market, interest, credit, international, liquidity, operational and other. Market risks arise from asset price changes, market volatilities and manager style drift. Interest rate risks represent exposures to rate changes, curve changes and inflation. Credit risks are associated with counterparty risks, defaults, downgrades, and spread movements. International risks include country/political risks, currency activities and reporting differences. Liquidity risks refer to the debt financing for leveraged positions, meeting margin calls, or paying redemptions. Operational risks are the risks from inadequate or failed fund processes, people or systems. Other risks include such things as legal/regulatory risk, external event risk, general business risk, and reputational/”headline” risk. To properly manage your portfolio risk you need to measure risk. Risk measurement has 3 goals: a) uncovering known risks (risks that have been previously experienced); b) reporting portfolio risk in an easy to understand manner; and, c) uncovering unknown risks (risks that have not been experienced before). The most common risk measures for investments are beta for equities and interest duration for bonds. Investment managers generally also use more sophisticated measurements to manage risks, measurements that examine volatility (standard deviation), crisis behavior (drawdowns), risk-adjusted returns (Sharpe / Sortino Ratios) and diversification (index correlation). Statistically, there are problems with excessively relying on many portfolio risk measures. Risk measurement problems include: a) short histories with minimal data points; b) inexact valuations based on unsubstantiated price discoveries for illiquid securities; and, c) changing securities held in the portfolios. Even if statistical hurdles could be solved the resulting calculations can be easily misinterpreted. For example, a high standard deviation means that a fund is volatile. But assessing an investment based purely on standard deviation would unjustly penalize investments with high upside volatility. Therefore, investors need to use a mix of risk measurements.

Portfolio Risks and Hedge Funds

Tail Risks Many risk measures assume a normal distribution of results and concentrate on the area that is within 3 +/- standard deviations from the mean (99.7% of the activity). Measuring tail events (black swans outside the 99.7%) is difficult for two fundamental reasons. First, tail or extreme events are by their nature rare and thus difficult to measure. Second, common assumptions are often not appropriate when addressing extreme events. The Value-at-Risk (VaR) of an asset is aimed at measuring the largest loss that the asset could experience over a finite time horizon with a given probability (for example, a 95% confidence that daily losses will not exceed 5%). VaR is popular as a risk measure because it provides a succinct summary of large losses (tail events) in a manner that is simple to understand. What VaR does not reveal is the average loss that can be expected if the confidence level is surpassed. Another problem is that the VaR statistics cannot be combined. If an investor is given the VaR for separate investments, there is no easy method to determine the VaR for a combined portfolio. Stress test can provide information on the risk associated with the extreme region of the tail unexplained by the VaR. By focusing on maximum losses over longer time horizons, stress tests can identify anomalies that may not appear in normal market conditions. One simple stress test consists of collecting the worst price movements for each relevant underlying risk factor and aggregating them. Portfolios can be subject to stress testing to analyze behavior in a crisis situation.

Hedge Funds Traditional investment managers have generally been evaluated on their performance versus a benchmark, as measured with tracking error. Minimizing index tracking error is not the ideal way to manage risk. This relative performance approach started to lose favor with institutions in the 2000’s. A renewed emphasis on absolute performance has benefited the hedge fund industry. Hedge funds can be portfolio diversifiers and risk reducers. But many investors still want to avoid hedge funds due to concerns regarding expenses, transparency, liquidity and risk controls. Most of those investors have significant directional equity and interest rate exposure; hedge funds could provide diversification (lowering risk) from these naturally long positions. Increased diversification would, in part, be due to the greater number of securities and strategies utilized by hedge funds. The specific advantages of hedge funds include: absolute returns in up and down markets, low correlations to other asset classes, unconstrained investment strategies, capital preservation, and incentivized compensation. Beyond traditional long exposures, hedge funds create value by: a) shorting stocks (overvalued positions, hedges and relative value plays); b) buying illiquid securities (low volume securities, emerging markets and distressed securities); c) using leverage to magnify returns; d) convexity (option exposures with nonsymmetrical payoffs); and, e) nimbleness (market timing and short-term arbitrage opportunities). The investment tools used to implement these strategies come with inherent risks beyond what investors are exposed to normally. If a hedge fund manager has personal money in the fund, he/she will have additional incentives to increase risk oversight. A study by Feffer & Kundro indicated that half of hedge fund failures can be attributed to poor operational risk controls. Examples of operational risks in hedge funds include: deficiencies in back office controls; deficiencies in the administrator’s organization; legal and/or regulatory non-compliance; criminal acts; business interruption; and unethical corporate culture. Operational risks are unsystematic risks that cannot be diversified away and for which an investor is not rewarded for accepting. Proper operational due diligence by investment professionals can help alleviate the dangers from operational risks.

Portfolio Risks and Hedge Funds

Hedge Fund Portfolios There are numerous hedging strategies available in the market, but there are a dozen primary strategies. Event driven strategies include convertible bond arbitrage, merger arbitrage, distressed debt and opportunistic equity. Discretionary strategies include long/short equity, short biased and global macro. Other strategies include fixed income arbitrage, equity market neutral, CTA’s/managed futures, emerging markets and security risk arbitrage. Unfortunately, hedge fund categorizations are not statistically significant; the style indices do not meaningfully explain the behavior of individual funds. Low homogeneity within hedge fund groups can be explained by three elements: a) managers do not classify their funds correctly; b) databases misclassify funds; and c) classifications are unable to reflect the true dissimilarity among the funds. Hence, there are inherent risks in relying too much on a hedge fund’s strategy category and assuming a fund will behave in a pre-determined manner. Volatility of hedge fund returns has drastically decreased in the last decade, reflecting the institutionalization of the hedge fund industry and over-diversification of fund indices due to more funds. Over-diversification reduces the valuable idiosyncratic returns that hedge fund investors explicitly target. The more diversified a portfolio of hedge funds gets, the greater its correlation to the overall equity markets. The strongest evidence against over-diversification is the fact that the HFR Fund Index has a 0.86 correlation to the S&P Small Cap Index, whereas the average correlation of individual hedge funds is 0.38. This leads to the conclusion that over-diversification can destroy value. Studies have concluded that a diversified portfolio could be built with 20 underlying investments. Consolidation avoids duplication of exposure and excessive sensitivity to certain risk factors within a portfolio. When constructing a portfolio and selecting individual hedge funds a key issue should be whether fund returns are achieved through passive strategies (i.e. being long in rising markets) or active strategies (alpha). Investors should be willing to pay up for alpha (α), but not beta (β/market returns). Hedge funds should explicitly generate idiosyncratic/security-specific risk. The higher fees that funds charge are only justifiable if the funds create real alpha returns. To generate those excess returns (α) funds need to take risks and the risks need to be managed.

Conclusion Managing investment portfolios includes managing risks. Investors need to define the risk budget (risk tolerance in terms of volatility, drawdown, etc.); define the expected risk factor exposures (beta, duration, etc.); select the investment strategies and securities (based on the factor exposures); establish the portfolio weightings (using proper diversification tools/techniques); and, monitor/rebalance the combined portfolio as necessary. The use of risk management policies reduces both risk-taking (with a corresponding decline in the frequency of extraordinary gains) and significant aggregate losses. Portfolios should include hedge fund exposure to deliver diversification, increase returns, and reduce volatility. While hedge funds carry unique risk factors, the hedge fund industry’s annual return distribution tails have flattened out. By Thomas J. Barrett, CFA, CFP, CPA Chief Investment Officer, Alpha Strategies