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Are Hedge Funds Really Risky?

You hear a lot in the regular press and in the financial news about how risky hedge funds are and that they are speculative investment vehicles. Indeed, some hedge funds can be risky and speculative in nature, but this is an overgeneralization as hedge funds can come in many different “flavors.” Their underlying strategies can also have deviations that make them different even though they may seem the same on the surface. This is akin to one fund playing baseball and another two playing football – two different games. The two funds playing football are running different defenses, however, in that same game – one a 3-4 and the other a 4-3. Two funds labeled technology-focused, for example, can have two different strategies: one may hedge its exposure to the general market, while the other doesn’t at all. Anyone looking at two such funds would want to know the difference.

The term “hedge” in hedge funds is kind of a misnomer nowadays because as pointed out just before – some hedge funds don’t hedge. In their advent in the early 1900’s, hedging was a big proponent of the funds so they were afforded the name, “hedge funds.” The basic idea at the time and what exists with some funds today, was to hedge, say exposure to an industry or market by going long (buying) one stock and going short (selling a stock you don’t own but buying it back later hopefully at a reduced price) another…

Hedge funds vary in risk, so labeling all of them risky is unfounded.

If a fund manager thought Coca-Cola was underpriced and PepsiCo overpriced, he or she could employ such a strategy to buy Coke and short Pepsi. If news came out that stated soda drinking was skyrocketing or plummeting and both stocks rose or fell as a result, the gain or loss would be zero because the movements of each stock are cancelling each other out. (This of course ignores other factors such as the costs of initiating and exiting such positions and the payment of dividends. Hedge fund managers employing such strategies are usually investing large amounts of capital, so such costs are usually minimal in a relative sense. And for those unable to think in the abstract, I realize that Coca-Cola and PepsiCo aren’t exactly apples and apples as companies in their current forms. Just like Wu-Tang, though, this is for the kids.)

The dual long and short positions “hedge” the overall position to general industry movements. If Coke outperforms and Pepsi underperforms, everything works out great for the manager. If Coke falls in price and Pepsi goes up in price, however, the results can be disastrous. By shorting a stock, your losses are effectively limitless as a stock does not have a definite top but it can only go to $0 on the bottom.

As an asset class and part of a larger portfolio, many studies show that hedge funds actually contribute to the reduction of risk and volatility in an investment portfolio. A professor I had in college was a co-author of such a study and found that hedge funds as an asset class more or less have the same characteristics as U.S. corporate bonds, which are usually viewed as less risky but yield smaller returns than U.S. stocks. Hedge funds can invest in a variety of asset classes: stocks, options, bonds, commodities, real estate, MLPs, and all the different sub-asset classes of these asset groups. Thus, always comparing their return and risk profiles to stocks may not be warranted, but such things happen even when hedge funds don’t invest in stocks at all. A hedge fund could be labeled risky or as underperforming because it’s not compared correctly to the right benchmarks or other “players.” If you’re a good basketball player among your friends, would it be fair to compare your talents to LeBron James? Probably not. But it sure would be humiliating!

So like relationship statuses on Facebook, the answer to the question, “Are hedge funds really risky?” is “It’s complicated.”

- Andrew Sebastian

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