By Ronald J. Surz
There's an important aspect of hedge fund risk that is not currently being recognized, and its omission can lull investors into a false sense of comfort.
The "hedge" in hedge fund implies that risk is lower than it is in traditional investing.
When risk is measured as the standard deviation of returns across time, this implication is confirmed — standard deviations are in fact lower. However, a hedge fund manager or 130/30 manager has more choices at his control, like short selling and derivatives. These choices create a risk that we call implementation risk. Two managers with identical standard deviations, implementing the same strategy, can have substantially different performance results, primarily because of the way they employ the tools available to them. Implementation risk is cross-sectional, whereas return risk is cross-temporal. Two low-volatility return paths can lead to substantially different wealth accumulations.
To see how implementation risk works, consider the recent trend of long-only managers offering risk-preserving portfolios that are 130% long and 30% short or a similar variation, thereby maintaining 100% exposure. On its face this combination would appear to be a win-win: Net market exposure is unchanged, so risk is unchanged, and the manager can add more value by selling short companies identified as inferior. The realities, however, are that risk is indeed increased, even though traditional risk measures do not capture this, and value is only added if the manager is right about his short selling picks. In particular, implementation risk is increased because opportunities to both succeed and fail are increased.
To estimate implementation risk we use Monte Carlo simulations that generate all of the possible implementations of the hedge fund manager's strategy. In this way we can compare the opportunities for long-only to those for long-short. Monte Carlo simulations are well known to the alternative investments community. Randomly generated outcomes provide a backdrop for decision-making by revealing what could happen under uncertainty. Implementation risk can only be identified and measured through the revelations of Monte Carlo simulations because this risk exists in the cross-section rather than across time.
For this estimate of risk, I used portfolios of 30 stocks drawn from the Standard & Poor's 500 index. The Monte Carlo technique created 10,000 scenarios for each of the two strategies.
In interpreting the results, let's start with some things we can figure out without running Monte Carlo simulations. The 130/30 strategy is net 100% equity, so the expected return remains the same as the return on a long-only strategy; thus the medians of the opportunity sets are unaffected by the addition of short selling because return expectations are unaltered.
However, as the range of opportunities expands so does divergence. In the best-case scenario (the fifth percentile) the long-only portfolio returns 3.72%, while the 130/30 strategy returns 6.36%. In the worst-case scenario (95th percentile), the long-only portfolio returns -7.03%, while the 130/30 strategy returns -9.65%, an additional loss potential of 2.62 percentage points.
Interestingly, the standard deviation returns is about the same for 130/30 as it is for long only. It's the implementation risk that makes it essential for the manager to have skill if the investor is to be better off with long-short, even when standard deviation is unaffected.
Upon closer examination, implementation risk is the price that is paid for what hedge fund marketers call "free leverage." The pitch works like this: By going 130% long and 30% short you get 160% of your assets working for you (130% plus 30%), without any net increase in market exposure — a winner. Despite common belief, this free leverage does increase risk, namely, implementation risk.
The key point is basic. Investors ought to know all of the risks they are taking. The benefit of long-short investing is in expanded opportunities. But this is a two-edged sword. Without skill you're as likely to lose more as you are to earn more. Implementation risk tells you how much more, and reinforces the need for greater due diligence.
Success in the hedge fund world can be substantial, and it can come with little apparent increase in risk, but there's symmetry on the downside as well. Hedge fund due diligence can be improved through the use of Monte Carlo simulations that compare the manager's actual performance to all of the possible implementations of his strategy, thereby capturing both traditional and implementation risks.
Ronald J. Surz is president of PPCA Inc., San Clemente, Calif., a performance-measurement technology firm, and is a principal of RCG LLC, Boulder, Colo., a fund of hedge funds.