The hardest aspect about hedge fund properties is to understand that they present an entirely distinct category of financial instruments, therefore, deploying a traditional methodology commonly used for stocks and bonds, will lead to the unexpected and most questionable results.
The figure on the left depicts the most important issues of hedge fund investing from the practitioner’s point of view. The distinct hedge fund valuation and risk management problems can be outlined as follows.
- Non-normal distributions of returns. The core problem of the hedge fund quantitative assessment is their risk valuation that is derived from asymmetrical non-normal distributions of returns and, consequently, inapplicability of the mean-variance framework and CAPM.
- Non-transparency of hedge funds. The next problem of the lack of hedge fund transparency comes from their nature as private investment vehicles that have no formal obligation of disclosing performance and trading strategies to the public. Non-transparency of hedge funds results in two different issues. First, most common risk management applications based on the performance analysis of underlying assets, for example, the Asset Based Style Analysis, become inapplicable. Second, non-transparency increases the importance of comprehensive due diligence covering its qualitative and quantitative aspects.
- Hedge fund data biases. Two other aspects of hedge funds’ irregularities, data inconsistency and the discordance of their indices, are derived from the following factors. First, the information collected by the existing data providers is submitted directly by fund managers and not validated independently. This fact itself implies a high potential for misuse and various errors, random or intentional. Second, although an investor may find similar indices provided by different vendors, all the indices are hardly compatible and cannot be used as benchmarks of the funds’ performance. What should the appropriate style index be, if similar indices from various vendors are often uncorrelated? See more on the subject: Biases of Hedge Fund Data.
- Ambiguous hedge fund strategy classifications. Different vendors use different systems for the hedge fund classification, the rules of inclusion funds into indices, and commonly provide no verification of manager-declared trading styles. On the other hand, hedge funds may behave in discordance with their corresponding indices, while similar indices from different vendors may be negatively correlated. For example, only 11.9% of the Long/Short equity funds evidence a significant correlation of over 0.5 with their corresponding index, while 8.3% exhibit a negative correlation.
- Inapplicability of the mean-variance risk assessment methods for hedge funds leads to deploying the alternative solutions that take into account irregularities of distributions, for example, the Value-at-Risk. However, using the VaR as an objective function for portfolio optimization requires applying advanced global optimization algorithms, since the VaR is a non-convex multi extreme function.