Study Highlights Hedge Fund Risks
Wednesday, June 02, 2010

As regulation of the hedge fund industry moves closer, and negotiations begin over the character of the Directive on Alternative Investment Fund Managers (AIFM), new research highlights serious worry over hedge funds and the risks to investors.

The research from the European School of Management & Technology (ESMT), in collaboration with the Rotterdam School of Management, concludes that there is "a worrying disconnect" in the behaviour of investors in hedge funds and the subsequent performance of their investments, typically resulting in poor or volatile performance and exposure to unnecessary risk.

In a study of hedge fund performance according to investment style, covering 1,543 hedge funds over 10 years, the ESMT said its research "raises disturbing questions" about the way that hedge fund investors invest and their willingness to actively chase performance at all costs, irrespective of the potential level of risk to which they are exposed. As a result, the authors of the research take the view that greater regulation is necessary to protect investors and that the provisions of the controversial Alternative Investment Fund Managers Directive ought to be welcomed.

The research reveals that investors systematically reward investment styles that have performed well over the previous three quarters, effectively substituting different investment styles for one another regardless of whether they are taking on higher levels of risk. This results in the top performing investment style attracting nearly USD300m more capital than the investment style that performs most poorly. A differential of 1% in the performance of a given style attracts a further USD9m of investor funds. However, the volatility of hedge fund styles means that high performing investment styles often go on to underperform other investment styles in subsequent quarters.

ESMT calculates that approximately 13% of total net asset growth can be attributed to “style-based investing,” and 20% of the capital that is committed to the hedge fund sector.  

The ramifications of style-based investment are significant, with the research suggesting that focusing on investment styles results in a potential inefficient allocation of capital across the hedge fund sector. The danger is that as increasing amounts of capital chase given styles (potentially attracting more managers into that style in turn), momentum investment starts to take hold, forcing up the price of overheated securities.

Professor Baquero at the ESMT and an author of the research comments:

"We have a two-fold issue here: whether investors’ naivety is leaving them overly exposed to risk they are not properly evaluating, and whether the growth of the hedge fund industry combined with that naivety means the sector poses a threat to financial stability. The fact that investors appear unable to recognise the risks of different styles and chase performance at all costs could leave them vulnerable and unprotected. This is exacerbated at the individual fund level by the opacity and lack of regulation of the sector, which already means that there are significant discrepancies in the level and quality of information reported.

"Now is the time to discuss deep, substantial and effective regulation that will genuinely be of use to investors and protect our financial system for the future."

“Given that the minimum investment thresholds for hedge fund investing have come down substantially in recent years, expanding the market and opening it up to retail investors, it is important to consider the level of risk hedge funds – and misinformed capital flows – may pose.

“We already know from the financial crisis that hedge funds were previously making increasingly directional bets in a rising market, which forced them into a situation of having to painfully unwind their positions. This in turn exerted huge downward pressure on already fragile markets. If naïve investment combines with an increasingly expanding industry, systemic risk may yet be posed in the future by the larger funds. We need financial reform that will anticipate the threats of the future, as well as deal with those of the past. Increasing regulation and investor communication around hedge funds will help considerably in making overall investment much smarter.” 

Looking at the two top performing and two worst performing investment styles in each quarter over the study’s 10-year time horizon reveals considerable volatility in the relative performance of different investment styles. For example, one of the most volatile investment strategies, Dedicated Short Bias, came first or second for 39% of the period surveyed. But this same strategy gave the worst or second worst returns for 55% of the time.

When analysing the performance of different styles in the immediately following quarter, the research found that half of investment categories typically went on to outperform the winning style from the previous quarter. When comparing winners and losers over several subsequent quarters, the research finds that relative performance even reverses – with the losers increasingly outperforming the previous winners.

What is more, investors are also highly likely to reward very extreme movements in style, often associated with the riskiest areas of hedge fund investment. ESMT’s research reveals that if a particular style moves from bottom to top performer in a given quarter, it is rewarded with 6% of investor inflows, and 12% of capital over the following three quarters. Also, investors react strongly to sequences of relative performance.

Baquero concludes:

“Naturally, investors will be drawn to investments that demonstrate more favourable returns, yet our research acts as a cautionary tale about falling into the age-old trap of trusting to past performance. Despite the perception that hedge fund investors are more sophisticated, our research suggests that this is not the case and that investors are overly reliant on yesterday’s performance. This is particularly worrying at a style level as investors are, in effect, moving in and out of strategies irrespective of whether they are exposing themselves to higher or inappropriate levels of risk for their needs. Evidence of an uninformed supply of capital flooding the market raises serious questions both about the level of risk to which investors are personally exposed, and the potential level of risk brought to financial markets as a whole”.