Avoiding hedge fund landmines
The first hedge fund blow up eventually hit the local industry, with the Evercrest Aggressive Fund losing 66% during April on a leveraged short position against Sanlam. How does a hedge fund investor avoid being burnt?
Long only investors have numerous decades' data to help them understand the type of volatility and drawdowns they can expect from each of the traditional asset classes. Funds within each of these classes (equity, bond and property funds) tend to be strongly correlated with one another. In contrast, hedge fund investors are placing their money in extremely heterogeneous products, and therefore have to take even greater care to fully understand fund strategies and their associated risk-return behaviour. They can start out by asking the following essential questions.
Is the level of leverage appropriate to the type of trades in the portfolio? Being ten times leveraged in a fixed interest arbitrage fund is usually perfectly acceptable in the light of the low-risk trades, whereas being leveraged even only twice, could dramatically increase the volatility of a long bias long/short equity portfolio. In fact, levels of leverage should never be used as a risk measure in isolation, but always in conjunction with Value-at-Risk and net exposure levels.
Do investors have access to the list of underlying holdings in a hedge fund portfolio? More often than not there is nothing sinister about a decision not to disclose- even CEOs of listed companies do not reveal all the details of their business strategy. In fact, transparent short positions can increase the risk of the portfolio, as it renders the fund vulnerable to short squeezes. However, at the very least an independent administrator or risk manager should report to the investor on the number of long and short positions respectively, as well as the extent of the largest long and short position- as an indication of concentration risk.
Does the hedge fund structure limit the liability of the investor? Because short positions can, in theory, lead to an investor losing more than his capital, it is essential to invest via a vehicle or structure that limits the liability of the investor to the capital invested. A standard broker account or segregated portfolio does not provide such comfort.
How does one know that the figures reported by the manager are true to what is actually happening in the portfolio? To minimise the risk of misrepresentation, ensure that the hedge fund has an independent prime broker, fund administrator, client administrator and auditor before investing. Request monthly valuation statements and risk reports directly from the independent service providers, where possible.
Should the investor not have the time or expertise required to identify and constantly monitor an appropriate hedge fund investment, he might rather want to opt for a fund of hedge funds, which is usually highly diversified across different strategies that display little correlation to one another, which dramatically decreases the volatility of the investment. These products are also normally run by experienced alternative investment professionals, who have performed a proper due diligence on the underlying funds and monitor these investments continuously.
What can we learn from Evercrest? Steer clear from portfolios taking on large concentration risk- diversification remains a prudent investment principle. Make sure that you are comfortable with the level of leverage of the portfolio. And remember that hedging out market risk with short positions is no guarantee of consistent positive returns, as the stock could appreciate contrary to the predictions of the manager. However, unlike traditional portfolios, hedge funds have the tools (the shorting mechanism) to benefit from stock devaluations, a unique advantage.
By Lizelle Steyn, Manager Alternative Products, Nedgroup Investments
