Portfolio Risks and Hedge Funds
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
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
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.
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.
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
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