Are Hedge Fund investors sitting on a volcano?

by Olivier Le Marois and Raphael Douady, 2008

  • The Subprime Crisis impacted alternative investments from July 07 to March 08, mainly through “time bomb explosions”, i.e a massive draw down on hedge fund managers, with apparently nothing in their track records prior to June 2007 that could have suggested any potential high risk.
  • Using a return based risk model, an investor who in June would have only accepted to invest on Hedge Funds exhibiting “normal” risk patterns would have slightly over-performed during the crisis compared to an iso-weighted benchmark. This results from an effective elimination of extreme risk takers, but the benefit of this elimination is widely offset by the fact that it also eliminates successful risk takers, and completely fails in detecting time bombs.
  • Using a non-linear factor-based model, such as the one provided by Riskdata, an investor who in June would have rejected any potential “time bomb”, detected by comparing past draw downs with predicted ones (using the factor model), would have over performed versus the benchmark by 4%. This is due to a significant reduction of time bombs, while keeping successful risk takers in the portfolio.
  • This demonstrates that pure return-based models – even if sophisticated – are insufficient to support sound risk budgeting. They help reduce the level of risk, but do not reduce the “hidden” risk neither do they help select the “good” risk. This can be successfully achieved with an efficient non-linear factor-based model, which is the only approach that can help discriminate between the “lucky” managers and the “talented” ones.

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