Finwedge

Volatility, Hedge Funds and risk management

By the mid 2000s a lot of savers signed up for the mystique of alternative investments also called hedge funds where managers developed the practice of hedging, ie- betting on falling. But many funds struggled to make money since the financial crisis and it helped to send stocks on a tear. Warren Buffett and college students criticized them and claimed their money back. Buffet argued that hedge funds had always charged the investors in a wrong way, since they typically collect management fees even when performance were poor. Pension funds began to divest causing many hedge funds to close up shop. It all went wrong and old-money bankers and outsized investments was re-considered.

The typical fee structure was known as “two and twenty”. The funds keeps 20% of any profits, plus 2% management fee. Theorically, investors would have made money regardless of market conditions. The idea was to generate returns that don’t come from the market but to deliver an absolute return called “alpha” or smart beta. As a whole, different large institutions thopught that hedge funds had played an important role in diversifying portfolios, since they can reduce volatility and protect against downturns. But it is also true that managers with mediocre returns routinely earned more from the “two” that they did from investment gains. Up to 2016, hedge funds, Bloomberg highlights that on average, they produced roughly a quarter of the annual returns on stocks and lagged a broad index of bonds that is pretty low respectively to the expectations.

To date macro hedge funds post the largest drop as US equities fell and interest rates climbed on expectations of accelerating inflation. The HFRI Fund Weighted Composite Index declined by -1.84ยจ% for the month of February 2018, ending a 15-month streak of positive performance. As a conclusion, a degree of cautiousness is always required for the investors and savers. The really good point is that hedge funds using quantitative models, where buying and selling decisions are made by computers, are still attracting money. Moreover, the integration of the compliance rules and RegTech in their internal risk management routines should be the next step to make them again more attractive for investors and savers.