The Perception of Risk in Hedge Funds and ETFs

by: Richard Kang

Last week I spoke at the “Inside ETFs” conference produced by Exchange-Traded Funds Report [ETFR] and Financial Advisor Magazine. Unlike the vast majority of other ETF related events I have been to in the past year, this conference was not dominated by those employed by ETF provider firms but rather by financial advisors. And for a first time event, well … I’ve never seen that many attendees for an inaugural conference. Kudos to the organizers but it also says something about the growth of ETFs.

Anyway, on the afternoon of day one, I was a panelist on a discussion focused on investment risk. I ended up getting into a bit of an “anti hedge fund rant” which was not my intention and part of this blog entry is to clarify some points which could not be made simply due to the limited time allotted to our session. So, what follows is what I would have hoped to cover that day, either did cover in a relatively light matter or not at all, or have considered now that a few days have passed.

First, because this event was targeted towards financial advisors, my perception is skewed to what I know of this type of intermediary. From our session and confirmed at many other sessions, it seemed clear that the financial advisor’s role within the portfolio building function focuses more on asset allocation than anything else.

The comments from my fellow panelists (all financial advisors with strong acumen based on the discussions we had in preparation for the event) further confirmed this. Manager selection may be in integral part of the process but it seemed like rebalancing issues and related matters revolving around portfolio maintenance were of paramount importance. And this makes sense if they’re participating at an ETF focused event.

Now let’s focus on the subject of this post: risk. With a discussion on risk, an important point of differentiation is that between risk measurement and risk management. Over the years, I’ve seen many investment professionals increase their proficiency with risk measures such as standard deviation and correlation. Even more, some measures from college level math like higher moments and rather sophisticated downside measures like VaR are creeping into the more common industry dialogue.

More than one of my fellow panelists mentioned the use of sensitivity analysis as well as Monte Carlo simulations. This is the power of the desktop computer and the internet. But it is also a point which must be clearly understood when we shift our thought from measurement to risk management.

Risk measurement attempts to provide some increased certainty in what is an uncertain endeavor. Certainty about what we saw in the past … that’s for sure. Certainty about what will come in the future? Well, statistical inference is a whole in 2nd year math course so I won’t go there in this post. There’s a reason why legal disclosures in investment related marketing materials include the phrase “Past performance is not indicative of future performance.” That’s because it’s true.

The best I think we can say is that some investment methodologies may have greater certainty of behaving in some sort of way in the future. Note, some uncertainty still exists. For example, with backtested results based on an index, we can say that, as opposed to backtests from an active manager, there is less concern of active management risk which can include the risk of style drift, among others.

This leads to my next point of clarification. I think that the investment industry uses the idea of “more risk” or “less risk” too freely. What may actually be happening is not an increase or decrease in overall risk but simply a transfer of risk.

One simple example is the “active-passive spectrum” which I have referred to in the past several times. For the sake of simplicity, let’s just keep this in the realm of stocks and the stock market. At one end of the spectrum is the pure passive world. Think beta, think super low cost beta exposures like S&P 500 index futures contracts or the S&P 500 Spyder, (NYSEARCA:SPY). This is where believers in market efficiency reside and they believe that exposure to market risk will pay off in the long term via the equity risk premium.

The other end of the spectrum is the pure active world. Think alpha, think much higher costs paid in an attempt to beat the market. This is best exemplified by hedge funds. Since there are multiple definitions of hedge funds, this end of the spectrum should really include only those that are market neutral, or perhaps more precise “beta neutral”.

So let’s review. First, I’ve said that risk measurement is not the same as risk management. I didn’t say this before, but one of my concerns is that a process of risk measurement, no matter how thorough or robust, may lead to a false sense of security. That would, in fact, mean that risk measurement, if used inappropriately, could be counter-productive to the overall risk management function. This subject has been covered well in the best selling books of Nassim Taleb and I think both “Fooled By Randomness” and “The Black Swan” are required reading.

Essentially, at this end you should not be taking on any market risk as the manager has promised to outperform in both good and bad markets. If true (practically speaking, you will need that grain of salt if you accept this assumption), then you are not exposed to market risk but manager risk.

If you accept this paradigm of a see-saw of market risk versus manager risk, then for a financial advisor or any investor who decides to put some of their money within a particular asset class in ETFs versus an active manager, they are simply transferring risk. Anyone who says that by investing in an ETF over an active manager is taking the “lower risk approach”, I believe is mistaken. As much as I like ETFs, I believe this choice is one of taking on market risk over manager risk. Again, not necessarily less risk.

Another investor who shifts between money in a bank account and a broad market ETF's is also transferring risk. Actually, there are various risks which one is exposed to no matter which of these two paths one takes. The bank account clearly has the risk of not having enough funds for future spending as its growth is reduced due to unfavorable tax treatment and the future purchasing power is dependent on returns after inflation.

Second, I have differentiated between increased/decreased risk taking and risk transfer. Again, thinking this way may lead investors away from getting caught in the false sense of security that makes one think of various natural and man-made disasters. The Titanic is a good example. My first boss in the industry called it “banana peel risk”. These are more philosophical exercises which are not meant to cause higher blood pressure or an anal-retentive complex with the readers of this blog. This is just my opinion and I’m just trying to tell it like it is through my eyes.

Although I did not cover the above in great detail at the conference, what I did discuss was pretty close to this. However, what I did get a lot of feedback on after our session was my views on the fund space, both inside and outside ETFs.

One of my key points was that the evolution in the ETF industry was allowing investors to gain exposure to new asset classes and strategies. This would have the potential for investors to add further diversification to their portfolios and hopefully weather any sideways or downwards market, should that be the environment we now find ourselves in.

Another point I stressed was that the new niche ETFs coming into the marketplace are certainly not meant for everyone. This also applies to many alternative investments including hedge funds which I’ll get to in a minute.

The simply beauty of ETFs is that they are the ultimate Swiss army knife. For everyone who has or ever used a similar multi-tool, we all have our favorite of its built in tools. I happen to use the corkscrew more than anything else. I think the blade is pretty useless. Actually, over the Swiss army knife I prefer my 12-year old Leatherman multi-tool. Note that it has no corkscrew but is unique with its main set of pliers which is handy when fishing.

What’s my point here? I have two multi-tools and I find certain things of value with each of them. You probably have one or both of these in your toolbox and likely others, but only you know what works best for you in the common situations you find yourself in. I’m not big on brand loyalty and I just care about the quality/value proposition of a product and can only hope that it delivers as promised.

Similarly, I don’t have any brand loyalty with ETFs … I’d be surprised if many investors do. The worst an ETF can do is not deliver as promised. Anyone who says that an ETF is “bad” because it’s not diversified enough, covers an esoteric asset class or is too narrow by sector is closed minded and frankly arrogant.

Who are you to tell me or anyone else what to put in my portfolio unless you know my income needs, feelings on loss/volatility, time horizon or other parameters which determine my portfolio’s overall financial objective(s)? Now, if you’re my financial advisor and I’m paying for your advice, that’s a different story. Deep breath in … and now we continue.

Getting back to investing, after the 5 year bull run, investors likely need holdings to augment their core holdings. I’m not saying replace their SPY or EFA positions with a nanotechnology ETF or Chile fund. But there’s nothing to say that these types of holdings could provide improved risk-return characteristics in the future.

Now, some of the more controversial points I made last week were those around the use of hedge funds and even comments regarding hedge fund replication products. Well, as an extension to what I just said earlier, who am I or anyone to simply say “No” to the use of hedge funds?

However, when an attendee asked me during the Q&A session my thoughts on the use of hedge funds, I started with a simple one word answer of “No”. Furthermore, when another listener asked my opinion on option-based strategies, my response was leaning more towards caution rather than a simple stamp of approval. Yikes. Looks like I’ve just painted myself in a corner. Time to explain myself.

Hopefully what I say now does not bring into disrepute the financial advisory profession. But I believe that the vast majority of financial advisors do not have the adequate resources necessary to adequately process hedge funds into their program. Frankly, the same could be said for many, if not most investors.

I won’t get into this into too much detail because I’ve said it so many times before, but it takes a lot of specialized skills conduct the necessary qualitative and quantitative due diligence that goes into the vetting process of weeding out the many hedge funds that come knocking down one’s door. And there are a lot of them … again, too many participants trying to get that alpha … there’s just not enough to share. This leads to too many losers and not enough winners. Worse still, many of the “winners” are closed to new investors.

With hedge fund managers wanting to keep up with past performance in an ever changing and tougher world, leverage is often used in an attempt to juice returns. It all makes a lot of sense and you can’t knock them for doing what they do. The system allows them to get paid based on performance so if they’re able to try, they will.

However, if financial advisors are shifting from mutual funds to ETFs because of lower fees and the folly of “closet indexing” among many mutual funds, one has to wonder if the appeal for hedge funds is worthy. Many financial advisors find themselves accepting the fact that selecting hedge funds is as tough, if not tougher than with mutual funds. Hence,.the fund-of-funds is a common avenue. The unfortunate reality with FOFs is that their added layer of fees adds further necessary returns just to be break even and their tendency to perform closer to common benchmark equity indices is even greater than with single strategy hedge funds.

Buy quality? Goldman Sach’s Global Alpha hedge fund is a commonly cited example of where this line of thinking may not apply. In fact, many large institutional investors, backed by academic studies, have realized that emerging (read smaller) managers have the greatest potential due to their nimble operations to extract true alpha from global markets.

Whether there is consistent alpha from these managers is questionable, which leads to the idea of rotating managers more frequently than one may deem reasonable. But philosophically, it makes sense to me that small managers with knowledge “ahead of the pack” can outwit other participants who are relatively late to the game within a particular and likely newer/esoteric segment of the capital markets.

All of this led me to my answer of “No” to financial advisors getting into hedge funds. I was also not very accommodative to the new world of hedge fund replication products. One new entrant in the ETF industry has been cited in the press several times in regard to its product development in this area. Whether it’s a good product for the ETF marketplace, I can’t say right now and without full details, it’s hard to say yea or nay at this point.

The only thing that can be said for now about HF replication is that it brings a new benchmark for hedge funds to go after. I mean, any financial advisor might be able to say in the near future “Um, Mr. Hedge Fund Manager, I can go to a replication ETF with much lower costs to get something that might likely perform very similarly to your fund’s strategy without many of the risks that keep me up at night.”

This argument would be very similar to the idea of investors shifting from actively managed mutual funds to index funds or ETFs because of the closet indexing prevalent in many mutual funds. Clearly, the fact that so much beta is embedded in hedge funds in aggregate (a very important point to stress is “in aggregate”), is a telling sign and flaw of hedge funds that makes this new world of replication both insightful and alarming.

Of course, there’s no absolute “black and white” answer to the use of hedge funds or HF replicators and like other market participants, financial advisors must differentiate themselves from their peers. So, my “No” is in general but will find exceptions from those firms willing and able to allocate the necessary resources to a dedicated “hedge fund due diligence team”. Same goes for building an option overlay program.

Above is a chart showing the performance of some common equity benchmark indices with a broad hedge fund index. The main point I want to make here is that during the strong bull markets of 1993-2000 and 2003-2007, the hedge fund index was basically similar in scope and trend to an index fund. However, during the bear market of 2000-2003 it behaved like a high-yielding cash/bond position.

In other words, the hedge fund index seemed to have a built in put option in play that paid off well during the bear market. The conference attendee who asked about options may have had a chart like this in mind. My response to the gentlemen and my comment here is that an option overlay program makes sense depending on the confidence you have in your own market timing abilities. For many, market timing abilities are about as reliable as one’s knack for coin flipping.

One insightful friend of mine thinks of option overlays in this way: If you’ve made a lot of return during an extended bull market (think 2000 or 2007), why not spend some of that return on an insurance policy. You’d do the same with your life insurance policy if your income increases dramatically. You’d to similarly again if you move into a bigger house. Why not protect another important asset that has grown dramatically? Makes a ton of sense to me. Just too bad that insurance is very expensive … pretty much true for any type of insurance including premiums in the options markets.

And there’s the rub. No matter if we’re talking about adding higher fee ETF diversifiers, even higher costing hedge funds or insurance policies like a put option, it won’t come cheap and the process won’t be easy. But that’s pretty much the definition of alpha, ain’t it.

Mine is not the place to tell any financial advisor or investor what to do. It’s all about choice. If now is the time to think defensively for one’s portfolio, there are multiple levels of protection that can be applied:

  • Diversify further into developing markets and alternative asset classes/strategies,
  • Diversify beyond market cap weighted indexing to dividend weighted or other forms of fundamental weighted or even equal weighted indexing,
  • Shift asset allocation to decrease enlarged positions and build cash,
  • Perhaps even make a tactical call to hold excess cash,
  • Apply the use of options in various ways to provide non-linear payoff characteristics,
  • Apply the use of inverse ETFs or outright shorting.
Financial advisors, like investors, come in different types with various degrees of proficiency and complexity. If the above are some of the various steps to increased complexity, one’s own personal philosophy on investing will likely determine where they fit.

One thing’s for sure: The trend in the ETF industry towards niche exposures and specialized strategies such as inverse exposures lead most, including myself, to believe that the core positions like SPY and EFA have been done if not overdone. Investors are looking for the next step to finer tuned portfolios and this just makes sense. You can survive on meat and potatoes but multi-vitamins help just in case you’re missing something. This makes me think of the folic acid pills my wife took while she was pregnant. You just never know, and that’s the point of insurance. To conclude, my comments at the conference were clearly tilted against hedge funds and more complex strategies for the majority of financial advisors. It’s just my opinion and of course that stance is entirely debatable. But I make my final argument here: Perhaps in the overlying concern of uncertainty (not simply risk), one must ask themselves if it’s even worth the exercise. I mean, for most financial advisors, I can see the benefits of ETF-based investing or at least, biasing their clients’ portfolios with the use of ETFs.

I can even understand the benefits of using ETFs, among certain other instruments to gain exposures to developing markets, alternative asset classes and certain strategies. But adding hedge funds and somewhat complex derivative strategies … does it provide their clients greater certainty of success? Or perhaps a more succinct question: Does it provide clients a greater level of comfort to apply these strategies on top of the ETF based portfolio? Or does it not. For the financial advisor, there’s the real risk to consider in my opinion.