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Hedge Funds - Risks

Hedge funds are often mistaken to be very similar in risk to other types of investments and although they are often measured through the same types of quantitative metrics, hedge funds have qualitative risks that make them unique to evaluate and analyze. In the following section of this tutorial, we'll evaluate some of the most common risk metrics used in hedge fund analysis as well as some of the broad qualitative issues that should be evaluated.

While every type of fund may have a different set of risks for its investors to consider, there are three basic types of risks which are shared by the entire hedge fund industry.

Investment Risk
The biggest and most obvious risk is the risk of investors losing some or all of their investment. A key quality of hedge fund investment risk is the virtual Wild West landscape of the hedge fund industry (though strides have been made since the 2008 financial crisis). Fund managers, for the most part, have free-reign over the investment decisions they make in chasing alpha with their portfolios. Unlike many other types of institutions, hedge funds are not regulated. While a fund may be tagged as a global blue-chip equity fund, and in most respects would be considered a relatively "safe" hedge fund investment, the strategies implemented by fund management, such as the use of excessive leverage, can create levels of investment risk not expected by investors. Some specific types of investment risk include:

Style Drift
Style drift occurs when a manager strays from the fund's stated goal or strategy to enter a hot sector or avoid a market downturn. Although this may sound like good money management, the reason an investment was made in the first place in the fund was due to the manager's stated expertise in a particular sector/strategy/etc., so abandoning his or her strength is probably not in the investors' best interests.

Overall Market Risk
Both equity and fixed income funds, and overall directional move by the equity markets, can play a big role on the returns of a fund. For equity funds, although many may claim to be market neutral or have a zero beta, it is very difficult, in practice, to achieve such a balance, as the equity markets can move very quickly in either direction - especially down. In time of crises, correlations go to one, so even the most diversified portfolio will not be safe from a market crash.

Widening credit spreads are the biggest threat to the performance of fixed income funds. Since most fixed income funds take long positions in corporate bonds and short positions in comparable treasuries, adverse economics movements can cause the simultaneous increase in corporate yields while the Treasury yields to fall, thus widening the spreads between positions and hurting the funds' performance.

The use of leverage within the hedge fund industry is commonplace, since a smart leveraged position can magnify gains. But as we all know, leverage is a double-edged sword and even a small move in the wrong direction can put a major dent in a fund's returns, especially those funds which speculate heavily in commodities and currencies.

Fraud Risk
The risk of fraud is more prevalent in the hedge fund industry as compared to mutual funds, for instance, due to the lack of regulation for hedge funds. Hedge funds do not face the same stringent reporting standards as other funds, therefore, the risk of unethical behavior on the part of the fund and its employees is heightened. There have been numerous media reports of hedge fund managers who have bilked investors out of huge sums of money in order to live lavish lifestyles or cover up constant losses for the fund. Knowing your hedge fund manager and staying abreast of the literature provided to you by the fund are keys to protecting yourself from investment fraud.

Operational Risk
Lastly, operational risk refers to the shortcomings within the policies, procedures and activities of a hedge fund and its employees. For example, quite often hedge funds deal in the over-the-counter market, where positions can be tailor made to suit the needs of the involved parties. The biggest issue with OTC securities is in valuing them on an ongoing basis, since they are not publicly traded and very illiquid. This issue came to light in the early stages of the 2008 credit crisis, when seemingly no two institutions were able to accurately value the mortgage and asset-backed securities that had flooded the marketplace in the early 2000s. The very nature of the hedge fund industry creates operational inefficiencies and, thus, operational risks.

Evaluating hedge fund performance differs significantly from the analysis used in other investments because of their risk/return characteristics and unique strategies. Robust analytical software will provide not only the metrics mentioned above, but also a variety of other metrics that can add insight into the performance of a particular fund. The list of metrics can be endless and every analyst tends to gravitate toward a group of select favorites that provide enough information to determine whether due diligence should continue.

The single-strategy fund of funds, on the other hand, would require an investor decision to add exposure to a particular type of strategy. I would hope that this type of investor has the resources to evaluate such a decision and make an allocation to this fund after careful evaluation of the overall portfolio.

It is important to assure that the fund of funds has well diversified funds even though they may use the same strategy. For example, if evaluating a long/short fund made up of 15 to 20 funds, it would be prudent to understand the sub-categories of each of the funds, such as whether they are sector-specific, domestic or global, value or growth-oriented, the level of gross and net exposure inherent in their strategy, and others. Most funds of funds will do a good job of diversifying across a variety of sub-strategies, but an investor should make sure this is the case.

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