Several studies have made evident that the hedge fund industry has known different changes over the years; as an illustration, risk factor is certainly the one that has been subject to the biggest metamorphosis.
Market neutral funds actively seek to avoid major risk factors but take bets on relative price movements. Fung and Hsieh (1999) declared: “Market neutral funds refer to those funds that actively seek to avoid major risk factors, but take bets on relative price movements utilizing strategies such as long-short equity, stock index arbitrage, convertible bond arbitrage and fixed income arbitrage” (p. 10, Is Mean Variance Analysis Applicable to Hedge Funds?). By contrast with this idea, Michaud (1993) said that, for any given level of risk, long-short strategy can yield to higher risk. “Active returns are generally accompanied by increases in active risk” (p. 48, Are Long- Short Equity Strategies Superior?), emphasizing that long-only portfolios when used efficiently can dominate long-short strategies at level of risk. In other words, investors when forming a long-
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short strategy are generally over-optimistic about the characteristics obtained by the strategy, which is no more than a long-only portfolio with more risks.
Kat and Amin (2001) investigated whether hedge funds offer investors a superior risk- adjusted return trade-off and revealed that stand-alone hedge funds do not offer higher risk return. Understanding hedge fund risk extends much beyond a simple linear exposure to market risk; for instance, Amenc and Martillini (2002) stated that hedge funds are not only exposed to market risk, but are exposed to volatility risk, default risk and liquidity risk. Amenc et al. (2003) provided evidence that even hedge funds following a zero-beta non-directional approach are exposed to a variety of risks such as volatility risk, liquidity risk and credit risk.
Liang (2001) stated: “The year 1998 was a disaster for the hedge fund industry. On August 17, Russia defaulted on its ruble debt and domestic dollar debt causing a panic among investors and resulting In widened spreads between high quality debt and risky debt” (p. 14, Hedge Funds’ Performance: 1990-1999). The impact of financial crisis on hedge funds has demonstrated that hedge funds were heavily affected, leading to high risk in the market. In fact, a couple of funds had to close because of poor performances.
Since then, the literature has tried to understand hedge fund risk. Fung and Hsieh (2001) presented a vast methodology to understand hedge fund risk by focusing on trend-following strategy; to do so they used CTAs75 funds because they are said to be trend-following strategies. The goal of this article was to model how trend-followers’ funds achieved returns and in consequence define the characteristics for assessing the systematic risk of their strategy. In a similar manner, Siegmann and Stefanova (2009) examined whether the inflows of money into the US stock market after 2003 had impacted hedge fund exposure to systematic risk. Systematic risk results from conditions, events and trends occurring outside the scope of the investment; investors should understand the rules to reduce the risk. Agarwal and Naik (2004) suggested that the expected tail losses identified by the mean variance can be underestimated by as high as 54% compared with M-CVaR optimal portfolios, suggesting that ignoring the tail risk of hedge funds can result in significantly higher losses during market downturns.
Ackerman et al. (1999) examined the components that suggested hedge funds are more risky than mutual funds by providing insights analysis. Also, they provided significant results that US hedge funds could be more risky than offshore hedge funds even after controlling for
75 CTAs are individuals or trading organizations registered with the Commodity Futures Trading Commission (CFTC) through membership in the National Futures Association, who trade primarily futures contracts on behalf of a customer.
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differences in the categories. Cassar and Gerakos (2011) examined the determinants and effectiveness of methods that hedge funds use to manage portfolio risk and revealed that risk management practices are a function of hedge fund characteristics, such as leverage, number of positions and the capital invested. Also, they found that hedge funds that did use normal portfolio risk metrics did well during the 2008 crisis. Billio et al. (2012) examined dynamic risk exposure of hedge funds to various risk factors during different market volatility conditions using the regime-switching beta model. They find that during times of high volatility in the market most of the strategies are negatively exposed to the large-small and credit spread risk and change in VIX (volatility index), suggesting that liquidity risk and credit risk are common factors in downturn of the market. Indeed, these factors are important in accessing hedge fund risk during downturn in the market. Solely, exposure can be different during up or down markets.
Several studies have observed that hedge funds are important providers of risk-adjusted performances. Brown et al. (1999) examined the performance of offshore hedge funds over the period 1989 to 1995, using a database that includes both delisted funds and currently operating funds, by investigating whether the returns to hedge fund investors are predictable from past reported returns. When investigating this pool of offshore funds, they found significant results regarding positive risk-adjusted performance measure by the Sharpe ratios76 and by Jensen’s alpha77.
Liang (2000) found that hedge funds have a higher Sharpe ratio than mutual funds. The average Sharpe ratio was 0.44 for hedge funds compared to 0.26 for mutual funds. Ackermann et al. (1999) also found that the average Sharpe ratio for hedge funds is higher than for mutual funds and reported a figure of 21% higher. Furthermore, there is evidence that hedge funds are important providers of liquidity in various financial markets. Siegmann and Stefanova (2011) found a positive relationship between market illiquidity and the market exposure prior to 2003 for hedge funds. As stated: “Before 2003, hedge fund acted as suppliers of liquidity, having a higher market exposure when stocks are undervalued due to low liquidity” (p. 20, Market Liquidity and Exposure of Hedge Funds).
Also, Boyson et al. (2010) examined evidence that hedge fund contagion can be linked to liquidity shocks, whilst Bekaert et al. (2005) said contagion can be defined as: “Correlation over
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Sharpe ratio is a measure of risk used to evaluate fund performances; the higher the Sharpe ratio the better are the fund risk-adjusted returns.
77 Jensen’s alpha is the difference between a series and its expected return on the market; in other words, it is the excess return above the market.
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and above what one would expect from economic fundamentals” (p. 66, Market Integration and Contagion).
Recently, Ribeiro and Santos (2011) examined whether market neutral strategies are exposed to the equity market and if so whether they are in part neutral to that market. Using data from January 1998 to December 2008 they formed an analysis of market neutral strategies. To do so, they examined what kind of strategies consistently outperform over time considering four strategies of market neutral hedge funds. Their results suggested that the strategy does not perform differently than the traditional capital market, suggesting that the neutrality given by hedge funds is not entirely accurate. Also, they stated: “Our results lead us to conclude that arbitrage and pure alpha strategies in hedge funds are not as accurate as their name and investment styles may imply, and their neutrality facing the securities market seems compromised” (p. 20, Market Neutral Hedge Funds Strategies: Are they Really Neutral?).
The authors also added a critical view to the neutrality displayed by hedge funds suggesting that diversified hedge funds are not market neutral; during the period under review the strategy exhibited significant market exposure. Despite market neutral, event driven, macro and short selling types of hedge funds performing reasonably well during periods of downturn in the market, commodity funds can offer greater insights during a bear market.
In short, risk measures including illiquidity risk exposure are a challenge for hedge funds. Despite the fact that systematic risk is likely to increase, in the future hedge funds managers would have to develop new techniques in order to fully understand the constituents of the market.