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By M. Isi Eromosele
Investments made by sophisticated individual and
institutional investors in private investment companies like hedge funds and
private equity funds are referred to as alternative investments.
These investments are frequently combined with financial
leverage to bear risks that may be unappealing to the typical investor or that
require flexibility that public investment funds may not provide.
It is often misunderstood that there is a real possibility
of a complete loss of invested capital. Moreover, the aggregate performance of
these unappealing positive net supply risks tend to be correlated with
aggregate economic conditions, such that losses are more likely when other
positive net supply assets are also experiencing losses.
An interesting implication is that investors relying on
traditional analyses for benchmarking alternatives are likely to be attracted ex
ante to strategies and historical return series that are highly levered
investments in safe assets that will turn negative in the event of a market
crash.
The Risk Profile Of Hedge Funds
To compute the required rate of return or cost of capital for
an allocation to hedge funds, one must first characterize the risk profile of a
typical investment. Rather than examine risk exposures of individual funds or strategies,
one should focus on the aggregate risk properties of the asset class.
Consequently, the cost of capital derived can be thought of
as applying to an investor in a diversified hedge fund portfolio (e.g. a
fund-of-funds, or an endowment holding a portfolio of alternative investments).
Another risk metric popular among practitioners is the
drawdown, which measures the magnitude of the strategy loss relative to its
highest historical value or high watermark.
The performance of hedge funds as an asset class is not
market-neutral. For example, hedge funds experience severe declines during
extreme market events, such as the credit crisis during the fall of 2008.
During the two-year decline following the bursting of the Internet bubble,
hedge fund performance was flat.
There are structural reasons to view the aggregated hedge
fund exposure as being similar to short index put option exposure. Many
strategies explicitly bear risks that tend to be realized when economic conditions
are poor or when the stock market is performing poorly.
For example, the aggregate merger arbitrage strategy is like
writing short-dated out-of-the money index put options because the underlying
probability of deal failure increases as the stock market drops.
Hedge fund strategies that are net long credit risk are
effectively short put options on
firm assets structural credit risk model such that their
aggregate exposure is similar to writing index puts.
Other strategies (e.g. distressed investing, leveraged
buyouts) are essentially betting on business turnarounds at firms that have
serious operating or financial problems. In the aggregate, these assets are
likely to perform well when purchased cheaply so long as market conditions do
not get too bad. However, in a rapidly deteriorating economy, these are likely
to be the first firms to fail.
The downside exposure of hedge funds is induced not only by
the nature of the economic risks they are bearing, but also by the features of
the institutional environment in which they operate.
In particular, almost all of the above strategies make use
of outside investor capital and financial leverage. Following negative price
shocks, outside investors make additional capital more expensive, reducing the arbitrageur’s
financial slack, and increasing the fund's exposure to further adverse shocks.
In extreme circumstances, the withdrawal of funding
liquidity (i.e. leverage) to arbitrageurs can interact with declines in market
liquidity to produce severe asset price declines.
M. Isi Eromosele is the President |
Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012 Oseme Group
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