Jun 04

Looking for less risk? Try hedge funds that use derivatives (academic paper)

by David Harper, CFA, FRM, CIPM

FRM |

  • Related FRM Learning Outcome: Summarize the empirical research on hedge fund performance.

Rene Stulz wrote a fact-packed reading on hedge funds that is FRM assigned (Hedge Funds: Past, Present and Future). He finds that hedge funds are less risky than long-only mutual funds (just for the particular historical period from 1994 to 2006, where the market proxy is the large-cap only S&P 500). His findings:

image

  CS/T Hedge Fund Index S&P 500
Annualized return 10.8% 10.3%
Volatility 7.8% 14.5%

In short, for that period (1994-2006), per unit of volatility, an investor who invested in the hedge fund index might have done about twice as well as an investor who invested in the S&P 500

Hedge funds the use derivatives versus non-users

How can hedge funds achieve less risk per unit of return? Typically, we cite the three general differences between hedge funds and mutual funds:

  • Derivatives
  • Leverage. Except leverage is neither a risk type nor a risk metric. It only amplifies the risk/return profile, so this cannot be a source of more/less risk per unit of return.
  • Ability to Short

Now an interesting paper published by Yong Chen of Virginia Polytech sheds more light on this and shows why risk varies by:

  • Use of derivatives. Hedge funds that use derivatives exhibited less risk: mean volatility of 12.6% versus 12.38% for non-users; mean beta of 0.187 versus 0.243 for non-users; mean idiosyncratic risk of 9.6 versus 9.7; mean downside risk of 0.012 versus 0.07. In short, "Hedge funds using derivatives display lower risk under several risk measures such as return volatility, market risk, downside risk, and extreme event risk"
  • The author also finds "that derivatives are more likely to be used by funds that charge higher incentive fees, have managers' personal capital invested, impose less stringent redemption restrictions, and employ effective auditing"

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