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Minyan Mailbag: No Respect For Risk?

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There is some statistical evidence that hedge funds and funds of hedge funds can return more return for less risk; of course there is no such thing as more return for no more risk.

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Prof. Succo,

I just read
this article from Feb. 2006 on Massachusetts state pension fund adding exposure to hedge funds. What really stood out to me was the following quote:

"A strategy of investing more money in hedge funds 'will give us the exposure to higher returns without giving us the risk,' Massachusetts Treasurer Tim Cahill, who's head of the pension fund's investment committee, said at the meeting."


I am by no means an expert on hedge funds, but with everything you have written about risk and fiduciary responsibility, this comment comes across as having no respect for risk. It is as though one just hires a fund-of-funds manager to parcel out money to individual hedge funds and voila, higher returns without the risk.

Do head of investment committees that oversee billions really believe it is that easy or is this just an obscure case?

Minyan Bryan


MB,

There is some statistical evidence that hedge funds and funds of hedge funds can return more return for less risk; of course there is no such thing as more return for no more risk.

There is a measurement called the "Sharpe" ratio that measures past extra return for a marginal increase in risk by dividing return by standard deviation normalized for the risk-free rate of return. A Sharpe ratio over 1 indicates an extra positive unit of return for risk.

First of all, this, like all statistics is linear in nature and only looks at past results. But the best hedge funds have exhibited positive sharp ratios over time. Pensions look at this and make comments such as you refer to.

Of course with the good you get the bad creeping in. Given the number of hedge funds and their growth you must be very careful. There are many nuances. For example, some investors invest only with new hedge funds that they think will be good at raising money. As a hedge fund raises money, there is a little tail wind to performance due to the fact that as new money comes in, the hedge fund increases the size of positions already owned and helps its own performance.

The hedge fund format and process, if executed correctly (if it operates opportunistically and controls risk, often a function of a correct investor base), may add alpha to a portfolio (although alpha cannot expected to be linear nor portable), but it is essential to pick the correct ones to manage that portfolio correctly over time.

There are many bad hedge funds and bad funds of funds, but there are many good ones too.

-Succo

No positions in stocks mentioned.

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