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Hedge Fund Risks

Hedge Funds

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Hedge funds are investment vehicles comprised of the assets which they hold as a basis for investment earnings. Hedge Fund risks are not uniform since their perils are derived from the financial assets held. Assets are not the only basis of risk: funds derive further risk from strategic choices they make, an easy example being the amount of leverage.

Hedge Fund Risks: Agency Risk

A key risk of hedge funds is agency risk, which occurs due to the construction of hedge fund fees. The compensation structure is highly skewed towards rewarding portfolio managers and general partners, who take large percentage of profits but do not share equally in losses. The performance fee is typically 20% of profits. This can be as low as 10% of profits or as high as 50%. When profits are positive they get their cut, but when profits become losses they get nothing.

If a fund is already suffering losses, general partners never have to reimburse investors for negative “returns”. They simply miss performance paychecks. Since they’re already losing this income, there’s no personal loss from taking on even more risk to get the performance pay back. If they fail, they lose nothing they haven’t already lost but if they succeed they earn it back. The same risk remains with a hedge fund watermark. If they lost 10% of the funds money last year, they must recover that 10% and then perform normally to continue earning performance expenses. They may take on excessive risks to cover the watermark distance. The agency risk remains.

Hedge Fund Risks: Asset Risk

Hedge funds derive a portion of their risk from the assets selected. If your fund owns high risk assets, your fund will have higher risks. You should expect appropriate compensation for the risks taken the in form of higher returns. If your manager is taking on high risk assets, you should be earning higher performance.

Receiving higher returns from higher risks is not your goal. The goal is the acquisition of higher returns at the same level of risk, generated purely from a manager’s experience and skill. This is known as Skill Alpha. Alpha derived from advantages in regulatory and oversight privileges is known as structural alpha. Almost all hedge funds share the same structural alpha, unless they have chosen to limit themselves from investing in specific assets or strategy by their own choice.

Many investors confuse themselves, believing that higher returns for higher risk are the same as higher returns at a typical level of risk. If your risk adjusted returns are not better than average you’re not receiving better performance from your manager. They are simply generating higher returns by taking on more risk using leverage or high risk assets. Always choose funds providing more return from lower levels of risk over funds generating higher returns with riskier behaviors.

Hedge Fund Risks: Control Risk

A hedge fund’s asset risk lends to another risk. When you hand control of your money to a portfolio manager for investment, they pick the assets. They ultimately have control over which assets are selected and responsibility over the selected asset’s results. You won’t get to request they purchase specific investments, or sell other investments.

You may think the only potential problem deriving from control risk is the chance managers will make terrible decisions. Negative decisions do not have to be negative performing assets; it can simply be unneeded increases in risk. Decisions which create overlaps with other parts of your portfolio increase risk. If a hedge fund manager selects the same investments within your portfolio and prices rise, they rise from profits together. If the portfolio falls, the hedge fund follows suit, increasing losses.

Control risk may inadvertently result in increased correlation, increasing risk when you are actually seeking diversification. You can avoid this aspect of control risk by investing in hedge funds with completely different investment, strategic, or regional targets than the rest of your portfolio. There is never a guarantee that the fund will not purchase the same investments as the rest of your portfolio.

Hedge Fund Risks: Credit Risk

Credit risk is the chance a trading partner will be insolvent. Credit risk applies to paying a debt or delivering an asset which you are owed. When you invest within a hedge fund, there are two layers of credit risk. If either of these risk levels fails, your returns will either slightly decrease, severely decrease, or disappear.

The first layer of credit risk is the possibility of obligations made to the hedge fund failing. This is not limited to bonds and loans. This can include mortgage related loans, futures, options, or any other contractual agreement’s delivery failing. These risks pass on to you. The hedge fund is investing your money. Your returns are dependent on the delivery of obligations to the fund.

The second layer of credit risk is the failure of the fund to deliver obligations they owe you. This occurs if the fund cannot finance your exit with the money promised or becomes completely insolvent due to loss, debts, or other issues. Occurrences are exceedingly rare, but can happen due to fraudulent activity or complete financial loss.

Hedge Fund Risks: Death Risk

“Death risk” is the possibility that a fund will close. This can occur for multiple reasons, but normally occurs after an extended period of bad performance by the fund. If a hedge fund has a large or growing watermark general partners may simply choose to shut the fund down rather than skip their paychecks. Watermarks are losses that must be recovered before managers can earn performance premiums. Alternatively, general partners may decide to simply kill off the fund if the fund’s poor performance results in a large amount of withdrawing investors.

Disbanding a fund due to poor performance is not necessarily a wise decision or beneficial for fund investors. Poor performance may be due to downswings in the business or industrial cycle, especially in niche funds which are limited to a specific area. Hedge funds may shut down before the business sector recovers. The returns which would repair investor losses are never received.

Hedge Fund Risks: Leverage Risk

Money borrowed from others constitutes leverage. Loans increase the amount of cash invested. The increase in base assets boosts gains since investors pay a lower percentage of the initial investments, but keep the same return. Leverage also increases any losses that occur, since Loans must still be repaid even if investments don’t deliver profits.

The first concern is the possibility that leverage will be owed on bad investments, costing the fund (and thus investors) additional losses. The second concern is the risks of loans borrowed for investments being called or revoked before their anticipated due dates. They could be forced to sell assets early to repay their loan, suffering heavy losses on the position.

Hedge Fund Risks: Liquidity Risk

Investors in alternative fund types can exit their funds on a daily basis. Examples of funds with daily liquidity are exchange traded funds, mutual funds, and some index funds. In most cases their investors only need to wait until the end of the day until funds will begin to facilitate their exit requests. This gives them the daily ability to liquefy their positions in a fund.

Hedge funds operate differently. Since managers set strategies up months or in extreme cases years in advance, they often place lockup periods in effect. This can be hard restrictions where you cannot withdraw at all, or a soft restriction which charges you a withdrawal fee (back-end load) if you liquefy holdings before a certain time period ends. In addition, hedge funds may reserve the right to suspend or restrict withdrawal rights during certain periods. The risk you will not be able to exit the fund to avoid losses or enter better financial opportunities increases.

There is a second layer concern for investors. Investments purchased or positions entered by the fund may become, or already be illiquid. Instead of exiting these investments to avoid crisis or seek other opportunities, the fund may be locked in an underperforming investment until it matures or a new buyer is finally found. This level of liquidity risk restricts a hedge fund’s opportunity to avoid losses or seek new profits for their investors.

Hedge Fund Risks: Market Risk

Market risk is simply the chance the firm’s investments will crash. This adverse effects of market risk rise with leverage, though the chance depends on the assets selected. Hedge fund managers often reduce the risk of market assets crashing below a certain value by “hedging”.

Hedging techniques decrease risks incurred by certain investment assets. Hedge Funds earn their name by actively reducing risk. Funds can use options, futures, custom derivatives, or investments with opposing correlations to achieve this goal. Options will secure a sale or purchase price when investment market values reach a specific level. Futures will secure a price for an investment in the future. Instruments with opposing correlations move inversely to another. As the price of one investment moves downwards, the other will move upward, either in equal or unequal fashion. All of these limit or reduce losses, but they also may limit or reduce gains as a trade-off. Note that every fund does not actually engage in hedging risks.

Hedge Fund Risks: Tax Risk

Tax risk is created by funds when they trade investments in a way that generates tax liabilities. Hedge funds can create tax inefficiencies when capitalizing on investments that are taxed at income tax rates. This will occur if funds invest too heavily in assets with returns that qualify as income taxes, or trade in a way which converts capital gains taxes to income tax rates.

Certain investments held longer than one year will qualify as capital gains taxes, which are currently substantially lower than income tax rates. Selling investments which would qualify as long term capital gains within the first year may trigger income level taxes. This forces investors to pay higher taxes than would otherwise be necessary. Increased taxes strongly reduce gains made through investments, sometimes as high as an additional twenty percent. These taxes are passed on to investors, so you should remain wary of funds which produce higher tax risks on your behalf.

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