BOOK REVIEW from Financial Analysts Journal
Hedge Fund Risk Fundamentals. By Richard Horwitz, Bloomberg Press, 100 Business Park Drive, P.O. Box 888, Princeton, NJ 08542-0888, www.bloomberg.com/books.
Reviewed by Murad J. Antia, CFA
Book Review Editor: Martin S. Fridson, CFA
(doi: 10.2469/faj.v61.n1.2688)
Despite their name, hedge funds do not invariably hedge their risks to protect against financial loss. In fact, Dictionary.com defines a hedge fund as “an investing group usually in the form of a limited partnership that employs speculative techniques in the hope of obtaining large capital gains.” As Richard Horwitz, director of risk management and performance analytics at Kenmar Global Investment Management, points out, hedge fund strategies range all the way from protective hedging to highly aggressive speculation.
Hedge funds' comparative freedom from restrictions gives them risk-and-return characteristics that are very different from those of traditional investment funds. Hedge funds can short securities, buy or sell options (thereby introducing convexity), use significant amounts of financial leverage, and follow asymmetrical trading strategies that effectively create synthetic options. Moreover, hedge funds tend to invest in illiquid instruments (under-researched assets trading in comparatively inefficient markets), such as private equity, restricted stock, and bank loans.
Illiquidity introduces “blow-up risk.” Hedge funds are commonly long the less-liquid instruments and short the more-liquid instruments. Financial crises, however, usually induce a flight to quality—that is, to liquid securities. Illiquid instruments consequently fall in value. At such times, hedge funds cannot monetize the illiquid instruments to raise cash either to meet redemptions or to fund margin requirements.
Notwithstanding the typical hedge fund's stated objective of generating positive returns in all market conditions, many equity hedge funds' returns have been significantly correlated with equity market returns. Recent history reveals that these funds were not nimble enough to reduce long positions and increase short positions in early 2000; consequently, they lost money for their investors. Many investors, not having been fully aware of their hedge fund risk exposures, were probably blindsided by the negative returns.
Institutional (long-only) investors have relied on multifactor models that measure portfolio bets relative to a benchmark and quantify the tracking error or active risk relative to the benchmark. These models appear to be ill suited to the needs of the hedge fund industry, partly because the funds themselves, to maintain their competitive advantage, might not wish to divulge proprietary information.
Hedge Fund Risk Fundamentals explains the risks that hedge fund investors face and provides a framework for measuring and evaluating the risks associated with hedge fund strategies. The book seems intended to serve largely as a marketing tool for Kenmar's risk measurement model, which is explained in considerable detail. According to Horwitz, Kenmar's system provides consistent risk transparency without disclosing sensitive or proprietary data. The system is available via the Bloomberg Professional service, which allows individual hedge funds to control individual investors' access to some of the data.
Evaluating the merits of the system or comparing it with competing products is beyond the scope of this review. The reader should presume that the author's intent is to display the system in the most complimentary light.
Horwitz states that, although there is no shortage of hedge funds, “there is a shortage of institutional-quality hedge funds, hedge funds with the depth and discipline to satisfy sophisticated institutional investors.” Regrettably, he does not address the funds' ability to garner excess returns for investors as more and more of them compete for a limited supply of inefficiently priced securities. The financial press has recently highlighted the declining performance of hedge funds.
Certain of Horwitz's points run counter to conventional wisdom. For example, he regards funds that generate alphas by actively managing market exposure as more “attractive” than market-bias funds. Similarly, Horwitz contends that funds that maintain a consistent value bias (secondary bias) are “unattractive” whereas funds that actively move between long and short secondary risk exposures are “attractive.” The “very attractive funds,” in his opinion, generate returns from purely idiosyncratic exposures, such as stock picking or statistical arbitrage.
To support the claimed superiority of funds engaged in market timing or style rotation over funds that maintain a consistent bias, Horwitz needs to provide empirical evidence. Such information would be significant especially because it would dispute the long-held belief that it is unusually difficult to generate excess returns by timing the market. Has the hedge fund industry attracted an unusually gifted cadre of professionals with better timing skills than mutual fund managers? Or are the fund managers' impressive track records the result of investing in nontraditional and illiquid investments? Inquiring investors would like to know.
A final risk faced by hedge fund investors is asset mispricing. Funds often use “flexible” valuations that may be “based on dealer quotes.” In the case of mortgage-backed security derivatives, these valuations often vary by between 20 percent and 40 percent. Some funds discount restricted stock up to 50 percent (an illiquidity penalty); others incorporate no discount from the stock price. In addition, the intrinsic volatility and risk of illiquid securities can be hidden because brokers may not regularly update the quotes of illiquid securities. These irregularities are unusually difficult to detect or correct by any model or system. Consequently, investors need to interpret model-generated risk and performance data with caution.
Hedge Fund Risk Fundamentals contains an abundance of helpful information for investors who want to understand the intricacies and risk dynamics of hedge funds. The book is written with commendable clarity and provides a valuable glimpse into the workings of a rapidly growing investment vehicle.
