A Demystification Of Hedge Funds And The Risk For Investors

Written by Zachary Cefaratti, Risk Officer at Dalma Capital Management Limited a DIFC asset manager
specializing in Hedge Fund management.
www.dalmacapital.com
A demystification of hedge funds and the risk for investors
As investors in the GCC become increasingly sophisticated and continue to institutionalize there have
been pioneers, early adopters and latecomers in the development of an alternatives (hedge funds)
portfolio. The regions pioneers have been the sovereign wealth funds, with ADIA as the worlds largest
single investor in hedge funds. Some large and sophisticated family offices have followed the prudent
lead of the Sovereign Wealth Funds along with a handful of corporates, foundations and wealth
management firms but regional allocations to the asset class still ominously lag their western peers at
a time when the worlds institutional investors are increasing their hedge fund allocations.
Why sophisticated investors are selecting hedge funds?
The year 2014, which we previously proposed would be the year of the hedge fund is already seeing
large flows into the asset class and in 2015, the industry may manage more than $3.3 trillion according
to a report by Boston Consulting Group. The forces compelling inflows today are the same as those
driving flows to hedge funds historically they are primarily related to risk management.
10-15 years ago, the impetus to invest in hedge funds was to diversify overweight allocations to equities
as valuations were historically high and expected returns withered. Hedge funds provided uncorrelated
returns that were expected to mitigate exposure to expected market downturns. Historically, hedge
funds best relative performance was generated when markets faired poorly. Investors seeking to
protect gains from the equity bull market of the 90s sought hedge funds to manage risk and protect
their downside.
Today, expensive bond markets combined with increasingly dear equity valuations create a similar
yet in some ways starker backdrop as expected future returns on stocks and bonds fall in step. Inflows
and allocations to hedge funds are therefore likely to be best explained by investors seeking to protect
their downside as uncertainty grows amid expensive stock and bond markets.
Risk Matters
Risk is often defined as volatility, but it is certainly not perceived this way by private investors. The
probability of losses, particularly large losses, is a more pragmatic definition of risk for the individual
investor as losses destroy the rate at which capital compounds. To maintain a portfolio with long run
growth, investors must achieve positive return asymmetry this is where hedge funds excel.
Asymmetric Returns
A marketing phrase often used by hedge funds is that hedge funds produce equity-like returns on the
upside and bond-like returns on the downside. This statement may be an exaggeration and
oversimplification, but it is not entirely untrue based on historical performance of hedge fund indices.
Hedge funds typically generate more modest returns during protracted equity bull markets, but
outperform strongly during bear markets delivering a long-run return profile that is more positively
asymmetric than the market index.
The key to maintaining superior long-term returns and positive compounding is positive asymmetry,
which is achieved through robust risk management and avoidance of significant losses, as losses destroy
the rate at which capital compounds. Positive asymmetry is where hedge funds have delivered for
investors by reducing the relative downside investors inevitably experience as financial markets ebb and
flow. The end result is relative outperformance by hedge fund indices on both a risk adjusted an
absolute basis compared with major equity indices, such as the S&P 500.
Risk Management
Hedge funds typically manage risk based on the premise that superior long run returns can be generated
through strategic selection of assets. Most hedge funds seeks to buy assets that they believe will
outperform the market and sell/short assets they will believe will underperform. Short positions and
derivatives held by many hedge funds might be considered on a standalone basis to be risky and
speculative, but as part of a typical hedge fund portfolio these assets serve to offer protection or a
hedge against market downturns or volatility often reducing risk for investors.
Empirical evidence demonstrates the effectiveness of this approach with Hedge Fund indices posting
long run out performance on both an absolute and a risk adjusted basis when compared to most market
indices and other asset classes. By reducing market correlation and mitigating downside risk hedge
funds have emerged as an essential component of the prudent investors portfolio.