Hedge Fund Risks and Issues for Investors

The main reasons of investing in hedge funds is to diversify the funds and maximize the returns of the investors, but high returns comes with a cost of higher risk since hedge funds are invested in risky portfolios as well as derivatives which has inherent risk and market risk in it, which may either give huge returns to the investors or turn them into losses and investor may incur negative returns.

Explanation

Hedge funds appear to be a very lucrative proposition for investors with High Risk and High Return appetite, however, it does pose some challenges especially for the investors investing Millions and Billions of Dollars. There are some inherent issues of hedge funds that have also increased significantly post the 2008 Financial crisis.

Hedge Fund Investors from most of the countries are required to be qualified investors who are assumed to be aware of the investment risks and accept these risks due to the potentially large returns available. Hedge Fund managers also employ extensive strategies of risk management for protecting the hedge fund investors which is expected to be diligently since the hedge fund manager is also a major stakeholder in the particular hedge fund. Funds may also appoint a “risk officer” who will assess and manage the risks but will not be involved in the Trading activities of the fund or employing strategies such as formal portfolio risk models.

#1 – Regulatory and Transparency

Hedge funds are private entities with relatively less public disclosure requirements. This, in turn, is perceived as a ‘lack of transparency’ in the larger interest of the community.

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Another common perception is that in comparison to various other financial investment managers, the hedge fund managers are not subjected to regulatory oversight and/or rigid Registration requirements.
Such features expose the funds to fraudulent activities, faulty operations, mismatch of handling the fund in case of multiple managers, etc.
There is a push by the US Government and EU authorities to report additional information improving transparency especially post events such as the 2008 Financial crisis and the 2010 EU fall.
Additionally, the influence of institutional investors is pressurizing the hedge funds to provide more information on Valuation Methodology, Positions and Leverage exposures.

#2 – Investment Risks

Hedge funds share a number of risks as other investment classes broadly classified as Liquidity Risk and Manager Risk. Liquidity refers to how quickly security can be converted into cash. Funds generally employ a lock-up period during which an investor cannot withdraw money or exit the fund.

This can block possible liquidity opportunities during the lock-up period which can range from 1-3 years.
Many such investments employ leverage techniques which are the practice of purchasing assets on the basis of borrowed money or using derivatives for obtaining market exposure in excess of investors’ capital.
For e.g., if a hedge fund has $1000 to purchase 1 share of Apple Inc. but the fund manager speculates the share price to rise to $1200 post the launch of its latest iPhone version. Based on this it can leverage its position to borrow $9,000 from the share broker and in totality purchase 10 shares for $10,000. It is a highly risky proposition since there is no limit on the upside or downside risks. On one hand, if the share price touches $1200, the fund manager in total makes a total gain of $2000 (1200*10 = $12000 – Purchase price of $10,000). However, on the other hand, if the share price drops to $900, then the broker will give a margin call to the fund manager and sell all its 10 shares to recover the $9000 loan given. This will limit the loss for the hedge fund manager whereby there will be no gain on a 10% dip in the market price of Apple shares.
Another massive risk for all hedge fund investors is the risk of losing their entire investment. The Offering Memorandum (Prospectus) of the hedge fund generally states that the investor should have the appetite of losing over the entire amount of investment in case of unforeseen circumstances without holding the hedge fund responsible.

source: rbh.com

Also, have a look at How Hedge funds work?

#3 – Concentration Risk

This type of risk involves an excessive focus on a particular type of strategy or investing in a restricted sector for enhancing the returns.
Such risks can be conflicting for particular investors who expect vast diversification of funds to enhance returns in various sectors.
For e.g. the hedge fund investors may be having a defensive technique of investing the funds in the FMCG sector since this is an industry that will be operating on a continuous basis with a large scope of expansion as per the changing customer requirements.
However, if the macroeconomic conditions are dynamic like inflation challenges, high input costs, less consumer spending, in turn, will spur a downward spiral for the entire FMCG sector and hamper overall growth.
If the hedge fund manager has put all the eggs in one basket, then the performance of the FMCG sector will be directly proportional to the performance of the Fund.
On the contrary, if the funds have been diversified in multiple sectors like FMCG, Steel, Pharmaceuticals, Banking, etc, then dip in the performance of one sector can be neutralized by the performance of another sector.
This will largely depend on the macroeconomic conditions of the region where the investments are being made and its future potential.

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#4 – Performance Issues

Since the 2008 Financial crisis, the charm of the hedge fund industry is said to have waned out a bit. This is due to various factors related to interest rate formation, credit spreads, stock market volatility, leverage and government intervention creating various hurdles that reduce opportunities for even the most skillful of fund managers.

One area from where the hedge funds earn is by taking advantage of volatility and selling them. As per the below chart, the volatility index has been steadily declining downward since 2009 and it is hard to sell volatility since there is none to take advantage of.

This deterioration in performance can be pinned to the overabundance of investors. The hedge fund investors have now become very cautious in their approach and opt to preserve their capital even in the worse of conditions.
As the number of hedge funds has swelled, making it a $3 trillion industry, more investors are participating in the same but the overall performance has shrunk since more hedge fund managers have entered the market, reducing the effect of multiple strategies which were traditionally considered speculative in nature.
In such cases, the skills of a fund manager can carve a niche for themselves, by beating various estimates and exceeding expectations of general market sentiment.

#5 – Rising Fees & Prime Broker Dynamism

Fund managers are now beginning to feel the effects of bank regulations which have been strengthened post the 2008 financial crisis, especially the Basel III regulations.

These updated rules require banks to hold more capital through an capitalization rate which in turn blocks capital towards regulatory requirements, leverage constraints and increasing focus on liquidity impacting capacity and economics of banks.
It has also resulted in an evolving shift in how the Prime broker’s view hedge fund relationships.
Prime brokers have started demanding higher fees from the hedge fund managers for providing their services which in turn has an impact on the performance of the hedge fund and in turn making them less lucrative in an already squeezing margin business.
This has caused fund managers to evaluate how they obtain their financing or if required to make radical changes to their strategies.
This has made the investors jittery especially for those whose investments are in the “lock-up” time period.

#6 – Mismatch or Incomplete Information

It is the duty of the fund managers to reveal the performance of the fund on a regular basis. However, the results can be fabricated to match the directions of the fund manager since the offering documents are not reviewed or approved by the state or federal authorities.
A hedge fund may have little or no operating history or performance and hence may use hypothetical measures of performance which may not necessarily reflect the actual trading done by the manager or advisor.
Hedge fund investors should do a careful vetting of the same and question possible discrepancies.
For e.g. a hedge fund could have a very complex tax structure that may expose possible loopholes but not understood by the common investor.
Say, a fund manager may invest in P-Notes of the Indian stock market but routed through a tax haven. However, the manager may reveal of making such an investment by making all tax payments misleading the investors.
A hedge fund may not provide any transparency regarding its underlying investments (including sub-funds in a Fund of Funds structure) to the investors which in turn will be difficult for the investors to monitor.
Within this, there exists a possibility of getting the trades done through trading expertise and experience of third-party managers/advisors, the identity of which may not be disclosed to the investors.

#7 – Taxation

Hedge funds are generally taxed as Partnerships in order to avoid instances of “Double Taxation” and the Profits and Losses being passed on to the investors.
These gains, losses, and deductions are allocated to the investors for the respective fiscal year as determined by the General Partner.
This is detrimental to the investors since they will be the ones to bear the tax liabilities and not the hedge fund.
The fund’s tax returns are usually prepared by the accounting firm which provides audit facilities to the hedge fund.
Expenses are also passed on to the investors depending on whether the hedge fund is a “Trader” or an “Investor” insecurities during the year. The difference in treatment may change every year and the differences are:
If the fund is treated as a Trader, the investors may deduct their share of funds’ expenses,
If the fund is treated as an Investor, they may only deduct their share of funds’ expenses if that amount exceeds 2% of the investor’s Adjusted Gross Income.
Additionally, investors may also require the filing of state or local income tax returns with the Federal tax returns.
The drawback for the offshore investors, if not a tax-exempt is that their Profits shall be credited net of all expenses and tax liabilities.
For instance, the U.S. Government taxes all offshore profits at very high rates and imposing a non-deductible interest charge on taxes owed on any deferred income once the shares of the fund are sold or distributed.
In case of dividends as well, a “With-holding tax” is also imposed on the offshore investors which is generally in the range of 25%-30% depending on the country from where the investment is made and the taxation treaty shared with such nations.
Hence, if for local investors the tax liability would be in the range of 15%, for offshore such liabilities can climb to as much as 35%.

#8 – Problem of Plenty

Presently, the biggest problem faced by the hedge fund industry is the existence of far too many hedge funds.

If an investor wants to multiply his investment and generate a continuous trend of positive alpha (returns above the risk-adjusted return), the hedge fund needs to be exceptional regularly.
The issue for the hedge fund investors here is in which fund they shall proceed with their investments.
Most of the small hedge funds are currently struggling with the burden of additional costs being imposed along with Prime brokerage fees. As a result, for a fund to survive, it needs to have a reasonable rise in its Assets under Management (AUM) to at least $500mm for countering the increasing costs and risk appetite it needs to spur for earning large returns.
A fund in such instances will need around 3 years to break even post which it can earn profits and breach its “high-water mark” limit for charging Performance Fees.

Below is a sample table explaining the same for ABC Fund Ltd:

Year	Assets Under Mgmt ($MM)	Performance	Gross Income – Mgmt Fees($MM) (Assumed @ 1.75%)	Gross Income – Performance ($MM) (Assumed)	Expense ($MM) (Assumed)	Profitability ($MM) (Performance Income minus Expense)
1	50	12%	0.875	1.05	2.625	-1.575
2	100	12%	1.750	2.10	2.625	-0.525
3	200	12%	3.50	4.20	3.50	0.70
4	500	12%	8.75	10.50	5.0	5.50

From the above example, we can ascertain that as the Assets for the fund increases, so does the expenses. In this case, we are assuming the income to double every year and only then can it break-even once it enters the third year with assets of $200MM. It is from here that the skills of the fund manager come into play and need to ensure that the returns are increasing regularly so as to attract the cream of the investors in an ever-increasing and a competitive hedge fund industry.