As any regular reader of The Evidence-Based Investor knows, investing in hedge funds is a bad idea. The fees they charge are astronomical and the performance they deliver, in aggregate, has been consistently dismal for many years.
But there’s another fundamental reason to avoid hedge funds like the plague, and it’s this: they don’t even hedge.
To be more accurate, some hedge funds do act as a hedge to total portfolio risk for much of the time; but when you really need a hedge fund to come into its own — in other words, during a market crisis — that ability tends to disappear.
In a recent study called Hedge Fund Tail Risk: An Investigation in Stressed Markets, three researchers at the University of Venice in Italy examined hedge fund performance between 1994 and 2011.
In summary they found that:
- hedge funds actually contribute to the left-tail risk associated with market crises, largely because of their exposure to liquidity and credit risks;
- strategies typically employed by hedge fund expose investors to common risk factors such as size, value and momentum for stocks, and credit and term risk for bonds;
- strategies such as market neutral and convertible bond arbitrage, which reduce risk much of the time, in fact add to it during crisis periods; and
- being invested in a fund of hedge funds during a crisis fails to provide the diversification benefits normally associated with funds of funds, as all hedge fund strategies positively contribute to tail risk.
These findings are consistent with a 2012 study by Jan Wrampelmeyer entitled The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility, and are another damning indictment of hedge funds as an investment. After all, one of the main reasons investors use hedge funds is to hedge their bets, and yet the evidence shows that hedge funds fail to provide a hedge when they most need one.
The cheapest, simplest and most effective way to hedge is to hold a broadly diversified portfolio of low-cost index funds, with the right amount of exposure to stocks and bonds match your risk capacity. Job done.