| Research Brief: How to Avoid the Next Hedge Fund Blow-Up|
In light of recent developments in the hedge fund industry, it is prudent for fiduciaries to review their alternative investment programs. Although they can be quite viable, alternative strategies require more sophisticated due diligence and ongoing risk monitoring than do traditional vehicles. The following basic guidelines can help investors to avoid unpleasant surprises, and to increase their probability of long-term success.
Prudent use of alternative strategies requires a full commitment to sophisticated due diligence and ongoing risk monitoring. Although risk can never be completely eliminated, it can be reduced to an acceptable level with appropriate techniques. Adherence to the above guidelines is a good first step towards achieving long-term success with alternative strategies, and can help investors to avoid participating in the next hedge fund blow-up.
- Require Complete Holdings Transparency:
Managers sometimes demand secrecy, which can occasionally be justified. However, this arrangement is generally not prudent as it is difficult to effectively monitor risk without knowledge of all underlying positions in a portfolio. The returns-based and factor-based risk analyses provided by "black box" managers are often not sufficient to identify important sources of risk due to the non-traditional nature of the investments.
Complete transparency enables investors to fully understand return/risk characteristics, to independently value holdings (especially side pockets), and to recognize when managers deviate from their stated processes and risk limits. Without transparency and ongoing oversight, there is unlimited potential for abuse which is virtually impossible to discover until it is too late.
- Use Leverage Prudently:
To generate attractive returns from the exploitation of small inefficiencies, many alternative strategies require large amounts of leverage. This can be appropriate as long as the probability of large-magnitude losses is correctly modeled, and acceptable in relation to the return potential.
When leveraging, it is crucial to incorporate sufficient margin for error, as statistical relationships that have historically been stable can and do quickly explode to unanticipated levels, especially during times of market stress. When this occurs, markets often break down and liquidity evaporates, resulting in forced liquidation and extraordinary losses for those with insufficient margin to ride out the storm. Moreover, highly leveraged single-variable directional bets do not even require market stress and significant price movements to quickly turn disastrous.
- Measure Risk Appropriately:
Traditional statistics such as standard deviation and the Sharpe ratio should not be the primary tools used to evaluate most alternative strategies due to their non-normal and often significantly left-skewed return distributions. For example, the two strategies below have the same average return (10%), standard deviation (15%), and Sharpe ratio (0.43), but clearly the one on the left has a notably higher probability of large-magnitude losses.
Not only do traditional measures underestimate left-tail risk, but the true distribution profile is often not observable in a manager’s track record. For example, Long-Term Capital Management’s returns did not appear left-skewed until after it collapsed. The potential for these extreme events must be thoroughly considered and appropriately modeled when evaluating the viability of alternative investments.
- Investigate Hidden Correlations:
When engaging in a multi-strategy approach to alternative investing, it is important to consider non-traditional risk exposures. Strategies that may appear to be independent and uncorrelated based on their past returns might actually share common underlying exposures to volatility, liquidity, and other risks. As a result, diversification will not adequately reduce downside risk as these strategies will become strongly correlated and move together during periods of market stress. Diversification will backfire exactly when it is needed most.
- Limit Use of Long Lock-Up Periods:
Long lock-ups make it difficult if not impossible to exit favorably if a strategy’s viability, risk exposure, or process adherence becomes a concern. The ability to liquidate a sub-performing account in a timely manner and at a fair price is essential to long-term success.
- Favor Regulated Managers:
Regulation is not a replacement for thorough due diligence, but the additional oversight can help investors to avoid massive conflicts of interest and significant legal expenses. Moreover, side letters should not be used unless fully disclosed and thoroughly understood by all parties, portfolio valuations should be independently verified, and track records should be reported according to a widely accepted and uniform standard such as GIPS®.
- Keep All Expenses Low:
The significant management fees and transaction costs (both implicit and explicit) of alternative strategies all-too-often outweigh their return potential, especially when there are too many managers chasing the same small inefficiencies. Consistent net-of-fees alpha is difficult to generate in any market, and therefore expense control is crucial to long-term success. If a strategy does not have a significant, sustainable edge and costs are not clearly identified and minimized, investors are better served by traditional low-cost strategies.
At Midwest, fiduciary responsibility is a serious matter. Therefore, our alternative market neutral strategy has been specifically structured according to the above guidelines. We are an independent Registered Investment Advisor, accounts are managed separately to provide complete holdings transparency, and there are no lock-up periods. Leverage is used in a highly conservative manner, and management fees are a maximum of 1% with no performance fee. We believe that this product is highly viable in the current environment, and please contact us for details.
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