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BAM Intelligence

Hedge Funds Choke In Crises

Among the arguments made for investing in hedge funds is that they reduce the tail risks of traditional portfolios. In other words, they are expected to at least avoid the impact of market crises.

Unfortunately, the 1998 implosion of Long-Term Capital Management and the global financial meltdown in 2008 demonstrated that this hypothesis is incorrect. In both cases, most hedge funds suffered large losses—losses that were often associated with large, simultaneous liquidation by investors, which in turn led to liquidity crises.

Monica Billio, Lorenzo Frattarolo and Loriana Pelizzon, authors of the study “Hedge Fund Tail Risk: An Investigation in Stressed Markets,” which was published in the Spring 2016 issue of The Journal of Alternative Investments, contribute to the literature on hedge funds with an examination of the risk and performance of a portfolio of hedge funds.

Using three measures of risk (volatility, value at risk and expected shortfall), the authors constructed a model allowing them to accurately predict portfolio volatility during normal times and capture in a realistic way stress moves during crisis periods in a manner consistent with the empirical observation that returns in many financial markets are characterized by distributions with fat left tails.

Their study, which covered the period 1994 through 2011, used data for eight equal-weighted equity-related strategy indexes from the Dow Jones Credit Suisse Hedge Fund database. Data is net of all fees and accounts for survivorship bias.

Hedge Funds In Times Of Crisis
Following is a summary of their key findings:

  • Hedge funds contribute to the left-tail risk of a portfolio, which appears during crises—most of the hedge fund strategy indexes exhibit significant negative skewness and excess kurtosis.
  • The contributions to tail risk are not limited solely to market beta. Hedge fund strategies also present exposures to other common risk factors that are well-documented in the literature, factors such as size, value, momentum, credit, term, volatility and the dollar.
  • Factors that contribute to tail risk include liquidity risk and credit risk.
  • Emerging markets exposure makes the greatest contribution to tail risk.
  • During crises, even strategies such as market neutral and convertible bond arbitrage contribute to tail risk (although over the full period they reduce tail risk somewhat).

The authors concluded: “The natural ability of some hedge fund strategies to be hedgers to the total portfolio risk disappears during crisis periods.” (The emphasis is mine.) They write: “This is important especially during crisis periods, as investors seek diversification and hedging benefits from hedge funds.”

Of particular interest is that the authors found “even the dedicated short bias strategy, which has the largest effect in terms of reducing portfolio volatility in normal periods, has the smallest capability of reducing volatility, with very small negative contributions and even some positive contributions in some months during the crisis periods.”

These findings are consistent with those of a 2012 study, “The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility.” The author of that paper, Jan Wrampelmeyer, found that hedge funds have significant exposures to risk factors that correlate with volatility and illiquidity, exposures that contribute to tail risk.

Conclusion

The bottom line is that, while investors in different hedge fund strategies believe they are gaining diversification benefits, the above findings demonstrate that this benefit was not existent during the recent systemic crisis. In fact, these strategies added to tail risk. Put simply, just when their hedging benefits were needed most, they not only failed to work, they increased tail risk as all strategies became correlated.

These findings only increase the puzzle surrounding what is perhaps the greatest anomaly in finance: Given the very poor performance of hedge funds, why do investors continue to pour money into them? Consider this: Hedge fund assets under management have increased from about $50 billion in 1990 to about $3 trillion today.

This commentary originally appeared May 31 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

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Larry Swedroe

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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