Although leverage is used in many hedge fund strategies, some do not use it at all.
Funds can increase their leverage in three ways:
- Borrow external funds to invest more or sell short more than the equity capital they put in
- Borrow through a margin account
- Use financial instruments and derivatives that require posting margins (and a smaller cash outlay) rather than purchasing the underlying securities.
The unique risks include:
- Liquidity risk - Occurs in very thin or illiquid securities. In extreme market conditions, liquidity problems can cause the collapse of the entire fund.
- Pricing risk - Some of the assets in which a hedge fund invests can be very complicated, making it very difficult to price the securities properly.
- Counterparty risk - Hedge funds tend to deal with broker/dealers. As such, there is always the risk that a particular broker/dealer may fail or simply cut off the hedge fund. In these situations, the downside risk for the hedge fund and all its participants is extremely serious.
- Settlement risk - Failure to deliver the securities by one or more parties to the transaction.
- Short Squeeze risk - A short squeeze occurs when you have to purchase the securities you sold short before you want to. This can occur because the investors from whom you borrowed the security need it earlier than anticipated.
- Financial squeeze - Occurs when companies find themselves unable to borrow or unable to borrow at acceptable rates. Overextended credit lines, defaults and other debt issues can cause a financial squeeze. Margin calls and mark to market positions may also result in financial issues.
Hedge Fund Performance
For some hedge funds, the ability to find their returns can be difficult because of the nature of the industry. However, studies have presented strong cases for investing in hedge funds biased on the following:
- They tend to have a net return that is higher than equity and bond markets.
- They tend to have lower risks than equities when measured by the volatility of their returns.
- Sharpe ratios tend to be higher than those of equities and bonds. The Sharpe ratio is the reward to risk measured as the mean return in excess of the risk-free rate divided by the standard deviation.
- Correlation of hedge funds with conventional investment is generally low but still positive.
Survivorship bias is an important issue that needs to be addressed when analyzing past performance of funds. In brief, survivorship bias results from the tendency for poor performers to drop out while strong performers continue to exist. In other words, unsuccessful funds are taken out of the performance presentations and only the ones that have performed well are included. Therefore, when analyzing past performance of funds, the sample of current funds will include those that have been successful in the past, while many funds that previously existed but underperformed and were closed or merged are not included. Performance returns can be misleading because they are based on only the funds that have survived and not the ones that died.
Researchers have demonstrated in recent years that survivorship bias can play a significant role in biasing past returns of individual securities, mutual funds and even equities of specific countries.
This is of particular importance when looking at hedge funds because they often do not have to comply with performance presentation standards. Survivorship bias results in an overestimation of past returns and leads investors to be overly optimistic in predictions of future returns. Survivorship bias causes the results of some studies to skew higher because only companies that were successful enough to survive until the end of the period are included. Similarly, mutual fund performance may be misleading due to survivorship bias if the fund family tends to merge or discontinue underperforming funds
A technique that some companies use in launching new products is to "incubate" funds. For example, a company wishing to launch a new series of mutual funds might provide ten managers with a small amount of seed money to start aggressive funds. Each manager is given two years to test his or her stock picking ability. At the end of the period, several of the funds are likely to have outperformed the market. Those successful funds are then made available to the public and marketed aggressively while the losers are silently discontinued. This is what is known as "creation bias".
Once you have an appreciation for the effects of survivorship and creation bias it's easy to see how companies can effectively guarantee long-term records of superior performance. By starting with a large number of funds and discontinuing or merging the poor performers, a company is left with just the cream of the crop.
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