Theoretical hedge fund risk
Look beyond actual and simulated performance
November 21, 2004

It's safe to say that hedge funds have now successfully penetrated the retail marketplace. Wealthier individual investors have many hedge funds from which to choose, as long as they have certain financial means. However, investors with modest portfolios now have broad access to hedge fund products in the form of segregated funds, linked notes, and closed-end funds traded on stock exchanges. The true potential risk exposure, however, should make all investors reconsider how they think about hedge fund risk, which ultimately affects if and how such funds are included in portfolios.

Improved risk-return profile

It is common for many hedge funds to promote themselves as offering the return potential of stocks but with the volatility - or downside risk - of bonds. Other funds - often categorized as 'opportunistic' - don't aim for such downside protection but they still hold themselves out as offering a better risk-return trade-off compared to traditional investments.

While some funds have and will deliver on such a lofty promise, you will observe a wide range of results among hedge fund managers - more so than with traditional managers, I expect. Over the past three years (ended September 30), nearly 40 percent of the hedge funds tracked by Morningstar Canada's Paltrak software lost money. Only about 1/4 of the broader group of mutual funds reported a negative return over the same three-year period - which saw mixed results for equity markets. And as the Canadian hedge fund universe grows, I suspect that the dispersion in performance will broaden.

The point of this is that the potential to find greater risk-return profiles among hedge funds brings with it the higher probability of getting stuck with a loser. But this also leads into the difference between theoretical and actual risk exposure.

Theoretical vs. actual risk

The 2004 World Series champion (baseball's top team honour) Boston Red Sox nicely illustrate my point. Prior to this year's major league baseball playoffs, no team had ever come back to win a best-of-seven series from a 3-0 deficit. Combining baseball, basketball, football and hockey in North America, only two teams (both in hockey) in 238 instances have come back with four straight wins to take the series after initially falling behind 3-0.

As you may know, the Red Sox became the first team in major league baseball history - and just the third team of all four North American sports - to win a best-of-seven series after losing the first three games. And they did it against the heavily favoured New York Yankees.

Realistically, nobody expected the Red Sox to win - in part because of the statistical history stacked against them and because of the 'Bambino's Curse' (that has haunted them since 1920). There is a lesson here for individuals and advisors interested in hedge funds.

Statistical misfits

Historical stock market data show that severe declines happen rather infrequently. However, it's interesting to note that they occur hundreds of times more often than standard statistical tools would predict. In other words, financial markets contain what's called 'fat tail' risk. The statistical tools also suffer from model risk.

Modern portfolio theory uses elegant statistical tools (i.e. standard deviation, VAR, etc.) and theories to quantify risks and probable outcomes. But this introduces two problems. First, most such measures assume a 'bell curve' pattern of returns - an assumption not supported by actual data. Second, predicting future outcomes based on historical data usually runs the risk of being wrong 1 to 5 percent of the time. That likelihood is even greater when you consider that the data doesn't really conform to the tools as previously noted.

While things like standard deviation and VAR may be useful for illustrative purposes, relying on them too heavily will put investors and advisors at risk of being surprised on the downside. Such surprises will happen more often than expected and have negative behavioural implications - namely that individuals will be unable to stick with a plan that has realized more than expected downside risk.

These are issues with all financial markets. And the patterns of hedge fund returns are even less fitting to standard statistical tools, making them even more difficult to assess a quantitatively. Hence, with hedge funds (which employ strategies involving short selling and leverage), the risk of a downside surprise is magnified.

Advice

In the end, I believe that hedge funds can add value in a portfolio context. However, the risk of a nasty surprise on the downside remains because it's just so difficult to get a clear handle on exactly what level of risk is really being assumed - even for seemingly conservative funds. Hence, everybody will sleep a little sounder if this asset class is included only after rigorous due diligence and in the context of prudent asset allocation.