Stockholm (HedgeNordic) – Investors typically invest in hedge funds for diversification, uncorrelated returns, and ideally, attractive returns. However, the hedge fund industry has evolved into a highly diverse space with a wide range of strategies that use different techniques and instruments and exhibit varying risk-return characteristics. This complexity can lead many investors into pitfalls that result in disappointing or event detrimental outcomes. According to Francois-Serge Lhabitant, CEO and CIO at Kedge Capital and Visiting Associate Professor of Finance at the Hong Kong University of Science and Technology, these missteps often arise from applying conventional investment tools and logic to hedge fund investments.
In his recently published paper, “Ten Common Mistakes Investors Make When Allocating to Hedge Funds (or How to Make Sure Your Hedge Fund Portfolio Will Disappoint),” Lhabitant reviews the most prevalent errors made when navigating the hedge fund universe. The mistakes include:
1. Targeting de-correlation.
When asked what they are looking for in hedge funds, most investors will answer ‘decorrelation’ with stocks and bonds. More generally, should investors be looking for assets that tend to move in the opposite direction to stocks and bonds? Do they really want an asset that loses money in a bull equity market? Most likely not. Reality is that investors are probably looking for an asset that should deliver positive returns when a traditional portfolio loses ground. Or even more realistically, they are after an asset that would deliver large positive returns during traditional markets’ large dislocations, while still performing well when equities perform. Technically speaking, they are looking for asymmetric conditional trends – something far away from what a linear correlation coefficient can capture.
2. Using hedge fund indices
Many investors use these indices to make strategic decisions about hedge funds. They fail to understand that hedge fund indices are overdiversified and consequently have little or no alpha. This is not a hedge fund issue, but an index issue.
3. Minimizing fees
The real issue is not the headline level of fees but the lack of performance. Paying peanuts usually attracts monkeys, and it is no different in the world of hedge funds.
4. Choosing high Sharpe ratio funds
The Sharpe ratio is meant to assess the risk-adjusted performance of one’s whole portfolio, not just individual components. In addition, it is important to remember that Sharpe ratios will not be beneficial to investors if the risk taken is too low. For instance, a fund with a Sharpe ratio of 3 and a volatility of only 0.5% p.a. will only generate a return of 1.5% p.a.
5. Acting as a hedge fund manager
Trying to time hedge fund managers is often futile. Hedge fund managers should be experts in their markets and have better information about their opportunity set. Investors in hedge funds also tend to exhibit two behavioral biases, namely recency and loss aversion. Recency bias leads them to favor recently successful hedge funds, presuming that their performance will continue. Conversely, loss aversion prompts investors to divest from hedge funds that have incurred substantial losses, fearing continued decline or enduring capital impairment.
6. Overdiversifying
Diversification – mitigating risk by spreading investments across a variety of assets – is a fundamental pillar of prudent investing. For traditional assets such as stocks, diversification is usually gauged by the number of stocks within a portfolio. More stocks typically imply better risk mitigation, as it disperses the specific risks tied to individual companies. Applying the same principle to hedge funds, however, can lead to ‘diworsification’.
7. Being short volatility
Several hedge fund strategies exhibit return characteristics like those of shorting put options, despite not actively trading derivatives. Regrettably, some investors solely focus on collecting premiums without further action, only to face significant losses when adverse events occur. Selling stock market volatility – essentially, insuring others against market moves – has historically been profitable over extended periods but carries undesirable asymmetrical risks.
8. Saving money on operational due diligence
Operational due diligence (ODD) involves evaluating the non-investment aspects of a hedge fund, focusing on elements like operational structure, legal documents, policies, procedures, internal controls, compliance, regulatory oversight, technology, and staff backgrounds. Despite its importance, many investors view ODD as a cost without immediate visible returns. Some may lack the resources to maintain robust due diligence teams, leading them to hire less experienced ODD personnel or rush through standardized questionnaires that may not adequately fit the fund’s specific characteristics.
9. Using static linear models
While alpha is a useful metric for assessing hedge fund performance, its interpretation must consider the limitations of linear regression models in capturing the complexities of hedge fund strategies and their true risk-return profiles.
10. The tyranny of the pie chart
In traditional finance, strategic asset allocations are often visualized using pie charts, which depict how a portfolio’s assets are divided among different investment categories. These pie charts are particularly suitable in the context of traditional long-only investments. However, in the hedge fund universe, such pie charts lose much of their utility. Unlike traditional investments, hedge funds employ a wide range of strategies that can be dynamic, complex, and sometimes highly specialized. Clearly, alpha strategies, such as those employed by hedge funds, require more nuanced approaches that consider the unique characteristics and risks associated with each manager’s strategy.
The paper can be accessed here.
