Each financial crisis is accompanied by a wave of corporate failures, to which hedge funds are obviously not immune. Although the public tends to accept the collapse of small to larger companies as a natural phenomenon, it generally views hedge fund blow-ups in a different light. Typically, media coverage of hedge fund failures will point to supposedly systemic problems within the hedge fund industry.

Hedge fund managers are often perceived as modern-day daredevil adventurers due to the high degree of flexibility they enjoy and the non-traditional aspects of the strategies they implement. Onthe one hand, they are believed to produce exceptional, almost legendary, returns; on the other hand, the impression that the capital they manage could vanish at any time generates irrational fears. This somewhat mystical image of hedge fund managers actually blurs reality. In particular, the risk of dramatic losses is not as high as it seems. Furthermore, the sometimes highly publicised failures do not in fact reveal the systemic problems of the industry as a whole, but the reckless behaviour of a few. An investor can therefore substantially reduce the exposure to potential blow-ups through proper due diligence and sound investment practices.

One of the reasons for the perceived high failure rate of hedge funds is that their attrition rate is known to be high, approximately 9% per annum. The latter rate is generally estimated by counting the number of defunct funds in hedge fund databases. This is misleading for two reasons. First, hedge fund databases suffer from well-documented biases, such as a reporting bias. More importantly, hedge fund failures should be distinguished from discretionary fund liquidations. Taking these elements into account, a recent study1 estimates the annual default rate of hedge funds to be approximately 3% for the period extending from 1995 to 2004. Comparatively, the annualised default rate of Moody’s global speculative-grade bonds over the same period stands at around 2.5%.

In addition, over 50% of hedge fund failures are associated with operational risks only, of which fraudulent acts are the most common2. Proper operational due diligence, especially regarding potential misappropriation and misrepresentation issues, helps to minimise these risks substantially. The remaining failures mainly relate to investment risks, which can be somewhat more difficult to mitigate as hedge fund strategies are very diverse and often complex. At first sight, therefore, it might appear natural to associate hedge fund blow-ups with systemic factors, and consequently to assume that hedge fund investors automatically have a high exposure to this risk. In fact, this is not true and a simple rule of thumb will help to avoid most blow-ups. Investors should keep away from managers who attempt to sail into what one could call the ‘Hedge Fund Bermuda Triangle’: leverage, concentration and illiquidity. Abiding by this rule alone will not prevent managers from making wrong bets or serious mistakes, but it substantially reduces the risk of being exposed to dramatic failures.

Most hedge fund strategies typically display one of these three features: leverage, concentration or illiquidity (see Table 1). Leverage is the most straightforward tool used to enhance returns and is essential in most arbitrage strategies. Concentration allows managers to increase their expected return by focusing on their best ideas and not diluting them due to excessive diversification considerations. As for illiquid assets, they carry an attractive liquidity premium that funds with low redemption frequencies, such as hedge funds, are able to collect. Consequently, it is legitimate, and desirable, for hedge fund managers to make use of their freedom and for the funds they manage to display one of these features. However, although when taken separately they can lead to attractive returns, when combined they are a recipe for disaster. Indeed, it is clear that most non-fraudulent hedge fund failures have been directly linked to a combination of two of these features:

• Leverage and illiquidity (Bear Stearns, Peloton)
• Leverage and concentration (Amaranth, MotherRock)
• Illiquidity and concentration (Focus)

Although historical events provide us with clear lessons, it is not always clear how to learn from them. This is because identifying blow-up risks requires more than simply analysing track records, as the true risk is not always visible in past performance. Surprisingly, many hedge fund investors still rely on volatility as their main indicator of risk and the Sharpe ratio is still widely employed as a risk-adjusted return indicator. Both are often used to justify an investment, even though, especially in the case of hedge funds, it has been shown that these measures give a partial if not misleading view of risk. Leverage leads to a negative skew that generally does not become obvious until after a crisis; illiquid assets lead to smoothed returns and therefore reduce volatility and the perceived risk; and, by definition, concentration leads to a high sensitivity to idiosyncratic risk. New, more sophisticated, quantitative tools have been developed in recent years in order to address some of these issues3. While these tools can help to some extent, some risk management decisions will remain purely based on qualitative considerations. Avoiding managers who combine leverage, illiquidity and concentration, is one such decision.

Talented managers should be allowed to sail freely and roam the markets as they wish in order to seek better returns. After all, an over-constrained environment would lead to the same problems that the traditional industry has had to face in the past at the expense of investors. However, while enjoying the benefits of investing in hedge funds, investors should not put their trust in those who attempt to sail through the ‘Hedge Fund Bermuda Triangle’, because they run the risk of following their predecessors into failure.

1. “Predicting Hedge Fund Failure: A Comparison of Risk Measures”, Bing Liang and Hyuna Park, February 2008.
2. See for example: “Mitigating Hedge Funds’ Operational Risks”, EDHEC Business School, 2005.
3. See for example: “The Challenge of Hedge Fund Performance Measurement: a Toolbox Rather Than a Pandora’s Box”, EDHEC Business School, 2006.

3A (Alternative Asset Advisors)

3A (Alternative Asset Advisors) is the alternative investment management division of the SYZ & CO Group and one of Europe’s leading specialists in the field. 3A is the investment manager for a number of funds of hedge funds, including ALTIN and the umbrella fund “Alternative Capital Enhancement”. Visit www.3-a.ch3A Biography

Biology

SAMICHAËL MALQUARTI
Head of Risk Management at 3A SA

Malquarti joined 3A in 2005 where he has been developing quantitative and qualitative tools with a view to managing risk in the context of funds of hedge funds. He holds a Masters in Mathematical Physics from the University of Geneva in Switzerland and a PhD in Astronomy from the University of Sussex in the UK.