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BAM Intelligence

Looking For Rewards In Hedge Fund Risks

Hedge funds often invest in high-risk, illiquid securities. Thus, it’s reasonable to expect that such risky investments are priced to deliver higher expected returns than publicly traded securities. A problem that has haunted hedge funds is that, if leverage is used (as it often is), bear markets can lead to margin calls.

The problem is then compounded when investor redemptions lead to hedge funds being forced to unwind large positions when the price of liquidity is especially high. The result can be large losses—losses that could, perhaps, even have been avoided if a trade could have been held to maturity.

Funding Risk Study

Sven Klingler contributes to the literature on hedge funds with his December 2016 paper, “High Funding Risk, Low Return.” Klinger investigated whether higher exposure to funding risk carries a liquidity risk premium that can increase expected returns. He also sought to determine whether it’s possible that higher exposure to funding risk actually generates lower returns.

His proxy for measuring the market’s liquidity is based on the well-known currency carry trade and is related to other measures of market liquidity, such as the Treasury-to-euro dollar (TED) spread and the VIX (the implied volatility of the S&P 500 Index). His data sample covered about 3,000 hedge funds and the period January 1994 through May 2015. Following is a summary of his findings:

First, Klingler found that “hedge funds with a high past loading on a simple funding risk measure (funds that are more exposed to common funding shocks) severely underperform hedge funds with a low past loading on that measure (funds that are less exposed to common funding shocks).”

The difference in the risk-adjusted monthly return of the portfolio that is long the hedge fund portfolio with the lowest loading on the liquidity factor and short the hedge fund portfolio with the highest loading was 0.54% (with a t-statistic of 2.46). Instead of being a “priced risk factor,” funding risk has the opposite effect: A higher loading predicts lower risk-adjusted returns.

Funding Risk Hurts Performance

Second, he found that “hedge funds with a high loading on the funding risk measure experience lower equity flows than funds with a low loading on that measure.” Here too the results were statistically significant.

And third, Klingler found that, as you should expect, the “effect of a high loading on the funding risk measure is significantly lower for funds with a lockup provision, that is, funds that are capable of preventing subsequent outflows.” Klinger also showed that his results were not driven by a few outlier months.

These results demonstrate how the fragile nature of hedge fund equity limits a manager’s ability to profit from funding risky positions. The results also conflict with the claim that hedge funds are capable of timing market liquidity, thereby earning higher risk-adjusted returns.

The historical evidence makes clear that hedge fund leverage is countercyclical to the leverage of major dealer-brokers, and that it decreased significantly during the financial crisis. Therefore, funding risk due to margin calls or increasing haircuts is an additional source of liquidity risk for hedge funds. Furthermore, the evidence shows that this risk has gone unrewarded, which is not good news for hedge fund investors.

This commentary originally appeared January 13 on ETF.com

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Chief Research Officer

Larry Swedroe is Chief Research Officer for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored 15 more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)
Think, Act and Invest Like Warren Buffett (2012)
The Incredible Shrinking Alpha (2015)
Your Complete Guide to Factor-Based Investing (2016)
Reducing the Risk of Black Swans (2018)
Your Complete Guide to a Successful & Secure Retirement (2019)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for MutualFunds.com and Index Investor Corner on ETF.com.

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