Fig.3 Performance — SPY versus equity long/short hedge funds 1.000 SPY HFRI Equity Hedge Index 10.9% p.a.


Source: IR&M, Bloomberg


7.2% p.a.


magnitude, their key priorities. Thus, some hedge funds are generally able to deliver consistent returns with lower risk of loss. Long/short equity funds, while somewhat dependent on the direction of markets, hedge out some of this market risk through short positions that provide profits in a market downturn to offset losses made by the long positions. Equity market-neutral funds that invest equally in long and short equity portfolios should not be significantly correlated to market movements. That does not mean there is no risk. It only means there is no directional market risk.


“Take care to sell your horse before he dies. The art of life is passing losses on.” — Robert Frost (1873–1964), American poet


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absolute terms. By asymmetry, we actually mean two things: an asymmetry with respect to the magnitude of positive versus negative returns, as well as an asymmetry with respect to the frequency of positive versus negative returns. If our objective is the positive, smooth, and sustainable compounding of capital, one needs a combination of both of these asymmetries.


“It requires a great deal of boldness and a great deal of caution to make a great fortune, and when you have it, it requires ten times as much skill to keep it.” — Ralph Waldo Emerson (1803-82), American essayist


One aspect of risk management obviously is the avoidance of losses, especially large ones. One reason for avoiding large losses is that they negatively impact the rate at which capital compounds, as mentioned before, and it takes a long time to recover from large losses. Fig.2 shows the underwater perspective (in index in percentage of its previous all- time high) of the two investments discussed earlier. When the line in the chart is 100, the strategy or asset class is generating new profits. The graph is a way to visualize losses and, equally important, the time it takes to recover from those losses. Generally speaking, it takes longer to recover from large losses than it takes to recover from small losses.


“The conventional view serves to protect us from the painful job of thinking.” — John Kenneth Galbraith (1908-2006), Canadian-American economist


SPY lost roughly 50% of its value twice in the last decade. It took years to recover from those losses. Equity long/short as an equity-related sub-group of the hedge fund universe lost much less during these


downturns. The practical relevance is that the pain from losing money is smaller, the recovery from the losses faster, and the long-term rate at which capital compounds is higher as a result.


If you think of it for a moment, a product with high fees should be superior to a product with low fees. The other way around would make no sense at all. Fig.3 shows the performance of these two investments. We apply a log scale for the swings of the two investments to appear comparable.


Higher returns and a smoother path The chart shows the benefits of the asymmetric return profile well: higher return and a smoother path over the long term. The chart visualizes where the superior performance comes from. It is derived mainly from a smoother path when things in capital markets go wrong (circled).


Concluding remarks A risk-uncontrolled portfolio is a potpourri of risks Returns are a function of taking risk. Hedge funds do not hedge all risks. If all risks were hedged, there would be no return. One difference between hedge funds and traditional long-only managers is that hedge funds hedge the risks where the portfolio managers do not expect to be compensated for bearing the risk. A traditional long-only portfolio, by contrast, is a potpourri of risks, some of which carry a reward, while others do not.


Hedging directional market risk does not mean nothing can go utterly wrong Many hedge funds do seek to hedge against various types of market risk in one way or another, making consistency and stability of returns, rather than


There is still a lot of myth with respect to alternatives being risky. Much of it is built on anecdotal evidence, oversimplification, myopia, or simply a misrepresentation of facts. Although hedge funds are often branded as a separate asset class, a point can be made that hedge fund managers are simply asset managers utilizing other strategies than those used by relative return long-only managers. The major difference between the two is the definition of their return objective: hedge funds aim for absolute returns by balancing investment opportunities and risk of financial loss. The same logic is applicable to constructing portfolios with alternatives. Where a single investment might be “risky,” it is the combination of different risks that makes a portfolio less sensitive to accidents and losses. Diversification might indeed be the only free lunch in finance. THFJ


ABOUT THE AUTHOR


Alexander Ineichen is the founder of Ineichen Research and Management AG (IR&M), a research firm focusing on investment themes related to absolute returns and risk management. The firm was founded in October 2009.


Ineichen is the author of two publications “In Search of Alpha – Investing in Hedge Funds” (October 2000) and “The Search for Alpha Continues – Do Fund of Hedge Funds Add Value?” (September 2001). He is also author of “Absolute Returns – The Risk and Opportunities of Hedge Fund Investing” (Wiley Finance, October 2002) and “Asymmetric Returns – The Future of Active Asset Management” (Wiley Finance, November 2006). He also wrote “AIMA’s Roadmap to Hedge Funds” (November 2008) which was, at that time, the most often downloaded document from their website. He is on the board of directors of the CAIA Association and is a member of the AIMA Research Committee.


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PERFORMANCE 01/01/93 = 100, LOG SCALE 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015


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